There is an old saying among commodity traders that the cure for high prices is high prices. The same is likely to be true of GameStop Corp’s options. and other targets that have become popular on the Reddit forums, argued a veteran options analyst.
The idea is just Econ 101: as the prices of wheat, oil or gold go up a lot, users naturally use less of the product. As demand is rationed, prices end up falling (the same idea works the other way around, with low prices seen as the cure for, you guessed it, low prices).
And so it can happen after the frantic purchase of call options last week, which gives the holder the right, but not the obligation, to buy the underlying security at a set price at a given time, at GameStop GME,
and shares in other heavily sold companies, said Julian Emanuel, BTIG’s chief share and derivatives strategist, in a Sunday note.
The strong purchase of call options was part of an effort by an army of individual investors organized through Reddit’s WallStreetBets forum to raise prices for heavily sold companies, forcing short sellers to buy back their shares and accelerating the rise . The purchase of the call option generated its own feedback loop, as the market makers, who sold the call options, bought the underlying shares to protect or neutralize their exposure to the market.
More details: As the options trading frenzy is raising stocks and raising fears of a market bubble
The strategy, as anyone who paid the least attention last week to markets or the news knows, seems to have worked very well. GameStop’s stock soared 400% last week, ending Friday at $ 325, after hitting a $ 500 high on Thursday. GameStop ended 2020 at close to $ 18 per share.
Read: GameStop short squeeze supplies new stock market services that track Reddit messages
Given these fluctuations, the implied volatility – a measure of the cost of an option – at a value outside the 1,000% chart proved to be cheap for options that expired last week, said Emanuel, noting in the graph below the increase in volatility realized in 3 days.
BTIG
But the story is likely to be different going forward, he said, arguing that the options “probably became too expensive to remain a source that fuels even more positives in a series of meteoric winners”.
To illustrate, he noted that an at-the-money call option (one with an exercise price equal to the share price) on GameStop due on February 19 costs about half of GameStop’s actual share price, or 580 % volatility. In comparison, called at-the-money on the S&P 500 SPX,
also due on February 19, it costs 2.5% of the real price of the index, or 26.5% volatility, he said.
As both options were in cash, they had no “intrinsic value”, a measure of the option’s profitability based on the strike price in relation to the share price. Instead, the premiums consisted entirely of the “time value”, based on the expected volatility of the underlying asset and the time until the option expires.
GameStop’s share fell 27% on Monday, while the Dow Jones Industrial Average DJIA,
rose 300 points, or 1%, and the S&P 500 advanced about 1.8%. The main benchmarks were recovering some of the ground lost in its worst weekly decline since October, a decline attributed in part to hedge funds and other investors by cutting long positions as well as reducing short positions.
The end result, said Emanuel, is that GameStop’s options and much of the speculative stock group powered by GameStop’s social media “now have very expensive options, perhaps prohibitively”.