Shares of a handful of companies like GameStop Corp.
GME 92.71%
a BlackBerry Ltd.
has made three-figure gains in recent weeks, as part of a frenzy fueled by individual investors. Here’s what you need to know.
Shares in GameStop have more than doubled in 2021, up from a 2.5% rise in the S&P 500. The video game retailer Grapevine, Texas, has become a favorite of online retailers investing in Reddit companies. forum WallStreetBets is invested.
These investors are targeting short sellers who bet the shares will fall because of what they see as the company’s challenges. Goldman Sachs Group Inc. ‘s basket of the 50 stocks with the highest short-term interest rates – Wall Street input that the shares will fall – rose 25% for the year to Friday. Rising stock prices with a lot of short-circuits, such as GameStop, have led to huge losses in hedge fund-hedging funds, resulting in a $ 2.75 billion emergency to save one of these businesses.
GameStop shares began to rise on January 11, after the company said it had agreed to add three new directors to its board, accelerating the protests in the days that followed. The gain reflects in part the popularity of recent months of momentum trading, the use of investing in companies whose stock prices are rising in the expectation that they will continue to do so, and an increase in options in recent years, enabling users to make big bets with a relatively small pre-investment.
How do the options appear here?
Options are contracts that allow investors to buy or sell a stock at a certain price, either on or until a certain expiration date. It has become increasingly popular among small investors over the past few years as brokers have traded it cheaper and easier. Option trading volume set a record last year with an average of just under 30 million contracts per day. This year, it is more than 40 million, according to Options Clearing Corp. an increase of more than a third.
Options are especially popular among users of WallStreetBets, which has emerged as an incubator for day traders exchanging trading ideas and packing in hot stocks.
How do GameStop traders use options?
Options consist of two types: call options, which give the right to buy shares under certain conditions, and put options that offer the right to sell them. The calls are especially popular with the WallStreetBets crowd because they are a cheap way to bet that a stock will rise.
Take the market action on Tuesday, for example. GameStop closed at $ 147.98 per share. At that time, call options that allowed investors to buy GameStop shares at $ 200 by Friday were trading at about $ 19 per share – a fraction of the cost of an actual share. If you bought such an option and GameStop increased, the price of your option will increase, and you can probably sell it at a quick profit. If you own real GameStop shares, you will also benefit from the rally, but you will probably not get as many returns as with the calls.
Alternatively, using options can help reduce the risk for investors. For example, if you buy GameStop shares, you can protect your portfolio by buying put options that allow you to sell GameStop at, for example, $ 100 per share. This way, if GameStop falls below $ 100, you can use the put options and compensate your losses on the shares.
Why do stocks rise when the action is in options?
If you buy a call option, someone else has to sell it to you. Usually it’s a market maker – an electronic trading company that buys and sells stocks, options or other assets during the day, such as Citadel Securities LLC or Susquehanna International Group LLP.
Market makers do not want to place long-term bets on the share prices of companies. Therefore, if such a business sells you a GameStop call option, the market maker usually hedges the risk through a separate trade. Often it will buy shares of GameStop.
More about GameStop’s Rise
In options lingo it is called delta hedging, and therefore heavy buying of call options can increase the price of the underlying stock. As the price of the stock approaches the level at which call options can be exercised – $ 200 in the GameStop example above – market makers can sharpen their stock purchases to maintain a neutral position.
According to data provider Trade Alert, GameStop’s trading volumes have exploded over the past two weeks. For most of last week, calls were trading more actively than selling them, a sign that investors were generally more clumsy than clumsy. Two executives with option market-making businesses said delta hedging has played a role in recent rallies of hot stocks like GameStop.
In extreme cases, it can become a self-reinforcing mechanism, with day traders buying more calls and driving market makers to buy shares, which increases the price of the stock and encourages more traders to act.
“It can have a life of its own,” said Steve Sosnick, chief strategist at Interactive Brokers.
What do the experts say?
The scale and pace of the rally in GameStop, BlackBerry and other stocks surprised Wall Street, and no one knows how long the profits will last or which companies might get caught up in the madness.
But industry veterans warn that a rally in a stock based on speculative call options by small investors will inevitably expire for a number of reasons. Among them: many of these businesses were under business stress even before rising stock prices sharply increased their valuations. Valuations and fundamentals are closely related over time, analysts say, and higher valuations often mean that stocks suddenly fall.
Investors who buy their call options early in the rally, and then leave before it is the first time, will make a profit, possibly quite nicely. Many have, judging by Reddit posts, with one user claiming to have made more than $ 11 million with GameStop calls.
But buying later in the frenzy when prices are already higher means extraordinary levels of risk, traders say. Many buyers will eventually own expensive call options that quickly increase value and are likely to expire worthless. Meanwhile, the rising stock is likely to put investors in the deep pocket back in the fight to bet against them. As day traders move to other stocks, the boom that boosted the three-digit gains is likely to be busy, warn traders and portfolio managers.
“Eventually a bigger bully comes in,” said Stino Milito, co-chief operating officer of Dash Financial Technologies, an options brokerage firm. ‘You get big guys saying,’ That’s ridiculous. It can not continue. ‘”
Write to Alexander Osipovich by [email protected]
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