The Merge is widely expected to be a "sell the news event", but huge open interest in low-delta call options makes the case for a possible gamma squeeze if the Ethereum price goes up significantly after the Merge.
What is a gamma squeeze
A gamma squeeze refers to the forced buying of an underlying asset by options dealers. Options liquidity is usually provided by dealers (market makers), who sell options and hedge their exposure. Usually, dealers dynamically hedge their deltas, so when a spot rises, they buy it and vice versa in order to keep the delta approximately at the same level. That works well in most cases but may leave dealers vulnerable if the spot moves a lot, forcing them to buy the rising asset and exacerbating the rally (or vice versa). More details on how this works can be found at Fool.com.
A famous example of a gamma squeeze (combined with a short squeeze) is the meme stocks rally in 2021. Distinctive features are a very steep short-term price rally and a huge volume (the chart below shows AMC squeezes in January-February and May-June 2021).
AMC share price (USD) and trading volume (millions of shares)
Record open interest in Ethereum options
In the last few months Ethereum options open interest has risen a lot, renewing records every week. This record open interest is very skewed in favor of deep out-of-money calls.
Ethereum options open interest by strike price
About 32% of the call options open interest (by notional value) matures on September 30, 40% on December 30, and 28% on March 31.
Ethereum options open interest by expiration date
So, most options with the largest open interest currently have low deltas, which will rally if the spot significantly rises.
Deltas of Ethereum call options
* My estimate based on current prices of options with the same distance between the strike and the spot
Possible “gamma” flow
At a first glance, the huge open interest of Ethereum options may limit a spot upside potential, because holders of these calls will sell them if price grows. However, most of these options have been bought at a higher spot reference and with a hefty volatility premium, so most of their holders will probably remain in deep losses unless the spot price rallies a lot and will continue to hold them instead of accepting the losses.
On the contrary, the huge open interest in out-of-money calls may lead to a gamma squeeze if the spot price rises significantly after the Merge. Based on the current structure of open interest (see charts above) and current deltas of the options with the most popular strikes and expiration dates (see table above), I estimate that a 20-25% rise in the spot price (to $1900) will increase deltas of the most popular options by 1.5-2 times. The notional value of outstanding calls is about $4.6 billion. Based on the same open interest data, my very approximate estimate of the current spot exposure of dealers is 15% of the notional value. So, a 20-25% rise in the spot price will force dealers to buy about $500 million (4600 multiplied by 0.15 and by 0.75) on the spot market to hedge their exposure. If the spot price increases further, dealers will have to buy more. If the spot continues ascending, dealers' demand will likely end approximately at $5000, because at this point most of the open interest will be hedged.
Effect on Ethereum price
Will $500 million move the spot price and how much? The current Ethereum market cap is $188 billion. Daily trading volume varies from $10 billion to $50 billion but usually sits between $15-20 billion.
0.5% of market cap and 3% of daily volume look significant but not game-changing. However, liquidity metrics suggest that $500 million is more than it might seem at a first glance. Uniswap estimates that the daily average +/-2% spot market depth for the period from June 1, 2021, to March 1, 2022, is just $110 million (at more than 2 times higher Ethereum price). Recent Kaiko’s estimate for 2% market depth is about 45000 ETH ($70 million).
Ethereum market depth (daily average for the period from June 1, 2021 to March 1, 2022)
Based on Kaiko’s figure, $500 million may move the Ethereum price by as much as 7%. The Merge may entice higher-than-usual trading activity, but exchanges may limit some operations to reduce risks, so the overall effect on market liquidity is not clear. I think $500 million will most likely move the spot by 5-10%. And remember, this price change will lead to more demand from option dealers.
It’s more difficult to quantify further action. All in all, I think the “gamma” flow is not a game changer, but a very significant factor. If there is a modest natural buying flow in addition to option dealers’ demand or if liquidity deteriorates, Ethereum may quickly rise from $1900 to $4000-5000. Natural buying flow (of those who had expected a lower price after the merge) may be particularly likely because of the common view of the Merge as a "sell the news event".
How to trade
The gamma squeeze initially requires a large price increase, which itself is not very probable. However, if Ethereum moves close to $2000 after the Merge, it may go up much further. Obviously, the big rally might not be the most likely scenario, but I believe its probability is very underestimated. I recommend 2 ways to trade this. First, don’t be short uncovered calls. Second, consider a (potentially just a very small) long position in lottery-type deep out-of-money calls (like $3500 or $4000 expiring on September 30).
*This communication is intended as strictly informational, and nothing herein constitutes an offer or a recommendation to buy, sell, or retain any specific product, security or investment, or to utilise or refrain from utilising any particular service. The use of the products and services referred to herein may be subject to certain limitations in specific jurisdictions. This communication does not constitute and shall under no circumstances be deemed to constitute investment advice. This communication is not intended to constitute a public offering of securities within the meaning of any applicable legislation.