How the Reddit stock rally went and GameStop options

GameStop’s shares began to take off on January 11, after the company announced it had agreed to add three new directors to its board, and the rally gathered pace in the days that followed. The gains partly reflect the popularity of recent months of dynamic trading, the practice of investing in companies with rising stock prices in the hope of continuing to do so, and a surge over the past year in options trading, which allows you to make big bets with a relatively low initial investment.

How are the options listed?

Options are contracts that allow investors to buy or sell a stock at a specified price, on or until a specified expiration date. They have become more and more popular with small investors in recent years as brokerages have made their trading cheaper and easier. Option trading volume set a record last year, averaging just under 30 million contracts per day. This year, that number is over 40 million, according to Options Clearing Corp. – an increase of more than a third.

Options are especially popular among WallStreetBets users, which has become a hotbed for day traders who exchange trading ideas and stack hot stocks.

How do GameStop traders use options?

There are two versions of options: call options, which confer the right to buy shares under specified conditions, and put options, which confer the right to sell them. Calls are especially popular with the WallStreetBets crowd, as buying them is an inexpensive way to bet that a stock will rise.

Take the market action on Tuesday, for example. GameStop closed at $ 147.98 a share. At that point, call options that allowed investors to buy GameStop shares for $ 200 each on Friday were trading for around $ 19 a share – a fraction of the cost of a live share. If you bought such an option and GameStop rallied, the price of your option would rise and you could probably sell it for a quick profit. If you owned real GameStop stock, you would benefit from the rally as well, but you probably won’t get as big a return as you would with calls.

Alternatively, the use of options can help reduce the risk for investors. For example, if you buy GameStop stocks, you can protect your portfolio by buying puts that allow you to sell GameStop at, say, $ 100 a share. That way, if GameStop drops below $ 100, you can exercise the puts, making up for your losses on the stocks themselves.

Why are stocks soaring if the stock is about options?

When you buy a call option, someone else must sell it to you. Typically, this is a market maker – an electronic trading company that buys and sells stocks, options, or other assets throughout the day, such as Citadel Securities LLC or Susquehanna International Group LLP.

Market makers do not make long-term bets on company stock prices. So when such a company sells you a GameStop call option, the market maker usually covers that risk with a separate transaction. Often, he will buy shares of GameStop.

In options parlance, this is called delta hedging, and this is why a massive purchase of call options can drive up the price of the underlying stock. Additionally, as the stock price approaches the level at which call options can be exercised – $ 200 in the GameStop example above – market makers may step up their stock purchases for maintain a neutral position.

GameStop options trading volumes have exploded over the past two weeks, according to data provider Trade Alert. For most of the past week, calls were more actively traded than puts, a sign that investors were generally more bullish than bearish on the stock. Two executives from options market management companies said delta hedging played a role in recent rallies of hot titles such as GameStop.

In extreme cases, this can become a self-reinforcing mechanism, with day traders buying more calls and pushing market makers to buy stocks, raising the stock price and encouraging more traders to get started. in action.

“It can take on a life of its own,” said Steve Sosnick, chief strategist at Interactive Brokers.

What are the experts saying?

The scale and pace of the rally in GameStop, BlackBerry, and other stocks this year has taken Wall Street by surprise, and no one knows how long the gains will continue or what companies might be caught in the next frenzy.

But industry veterans warn that a one-stock rally based on speculative buying of call options by small investors will inevitably collapse, for a handful of reasons. Among them: Many of these companies were under trade stress even before soaring stock prices sharply raised their valuations. Valuations and fundamentals tend to be tightly linked over time, analysts say, and higher valuations often mean stocks are prone to sudden drops.

Investors who buy their call options at the start of the rally and then exit before it ends, will benefit, perhaps quite generously. Many have already done so, judging from Reddit posts, with one user claiming to have made over $ 11 million in GameStop calls.

But buying later in the frenzy, when prices are already high, means taking extraordinary levels of risk, traders say. Many buyers will end up with expensive call options that will quickly lose value and likely expire worthless. Meanwhile, the surge in stocks will likely bring deep-pocketed investors back into the fray to bet against them. As the daytrading mob shifts to other stocks, the boom that fueled triple-digit gains is likely to collapse, traders and portfolio managers warn.

“Eventually, a bigger bully is coming,” said Stino Milito, co-chief operating officer at Dash Financial Technologies, an options brokerage firm. “You get big guys who say, ‘This is ridiculous. It cannot continue. ”

Write to Alexander Osipovich at [email protected]