There is an old saying among traders in commodities that the price of high prices is the best. The same is likely to apply to options on GameStop Corp. and other high-flying targets that have become popular on Reddit message boards, a veteran option analyst argued.
The idea is just Econ 101: as prices for wheat or oil or gold rise too high, users naturally use less of the product. As demand is rationed, prices eventually fall (the same idea works the other way around, with low prices seen as the solution to, you guessed it, low prices).
It could therefore go to the savage buying of call options last week, which gives the holder the right, but not the obligation, to buy the underlying security at a set time at a set price on GameStop GME,
and shares of other sharply shortened companies, said Julian Emanuel, chief equity and derivatives strategist at BTIG, in a Sunday note.
The heavy buying of calls was part of an effort by an army of individual investors organized by Reddit’s WallStreetBets forum to raise the prices of heavily shortened companies, which had to force short sellers to buy back their shares and rally to accelerate. The buying of the calls generated its own feedback loop because market makers who sold the call options bought the underlying stocks to hedge or neutralize their exposure to the market.
More details: How an options trading frenzy lifts stocks and raises fears of a market bubble
The strategy, as anyone who pays the least attention to markets or news this past week, seems to have worked pretty well. GameStop shares rose 400% last week to Friday at $ 325, after hitting near $ 500 on Thursday. GameStop ended 2020 close to $ 18 per share.
Read: GameStop’s short press releases new stock market services following Reddit messages
Given the gyrates, the implied volatility – one measure of the cost of an option – appears to be 1,000% cheap for options that expired last week, Emanuel said, noting in the chart below the 3-day increase -realized volatility.
BTIG
But that would probably be a different story going forward, and he argued that options “probably became too expensive to become a resource that went further upside down in a number of meteoric winters.”
By way of illustration, he noted that a call option on the money (one with a strike price equal to the share price) on GameStop that expires on February 19 costs approximately half the actual share price of GameStop or 580%. For comparison: the S&P 500 SPX with the money,
which also expired on February 19, it cost 2.5% of the index’s real price, or 26.5% volatility.
Since both options make money, they had no ‘intrinsic value’, a measure of the profitability of the option, based on the strike price relative to the share price. Instead, the premiums consisted entirely of ‘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 rose 1.8%. The key measures were to recoup the ground lost in their worst weekly decline since October, a decline attributed in part to hedge funds and other investors reducing long positions, as well as reducing short positions.
The bottom line, according to Emanuel, is that options on GameStop and many of GameStop’s group of speculative stocks fueled on social media now have options that are very expensive, perhaps excessively so. “