There’s an old saying among commodity traders that the cure for high prices is high prices. The same likely will prove true for options on GameStop Corp. and other highflying targets that have become popular on Reddit message boards, argued one veteran options analyst.
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 decline (the same idea works in reverse, with low prices seen as the cure for, you guessed it, low prices).
And so it might go after last week’s frenzied buying of call options, which give the holder the right but not the obligation to buy the underlying security at a set price by a certain time, on GameStop
GME,
-30.77%
and shares of other heavily shorted companies, said Julian Emanuel, chief equity and derivatives strategist at BTIG, in a Sunday note.
The heavy call buying was part of an effort by an army of individual investors organized via Reddit’s WallStreetBets forum to run up the prices of the heavily shorted companies, forcing short sellers to buy back their shares and accelerating the rally. The call buying generated a feedback loop of its own as market makers, who had sold the call options, bought the underlying stocks to hedge, or neutralize, their market exposure.
More details: How an options-trading frenzy is lifting stocks and stirring fears of a market bubble
The strategy, as anyone paying the slightest attention last week to markets or the news knows, seems to have worked quite nicely. GameStop shares soared 400% last week to end Friday at $325 after touching a high near $500 on Thursday. GameStop ended 2020 near $18 a share.
Read: GameStop short squeeze fuels new stock-market services tracking Reddit messages
Given those gyrations, implied volatility — one measure of an option’s cost — at an off-the-charts 1,000% proved cheap for options that expired last week, Emanuel said, noting in the chart below the surge in 3-day realized volatility.
BTIG
But it’s likely to be a different story going forward, he said, arguing that options “have likely become too expensive to remain a source fueling further upside in a number of the meteoric gainers.”
To illustrate, he noted that an at-the-money call option (one with a strike price equal to the stock price) on GameStop expiring on Feb. 19 cost around half of GameStop’s actual share price, or 580% volatility. By comparison, at-the-money call on the S&P 500
SPX,
+1.61%,
also expiring on Feb. 19, cost 2.5% of the index’s actual price, or 26.5% volatility, he said.
Since both options were at-the-money, they had no “intrinsic value,” a measure of the option’s profitability based on the strike price relative to the share price. Instead, the premiums consisted entirely of “time value,” based on the underlying asset’s expected volatility and the time until the option expires.
GameStop share were off 27% on Monday, while the Dow Jones Industrial Average
DJIA,
+0.76%
rose 300 points, or 1%, and the S&P 500 advanced around 1.8%. Major benchmarks were taking back some of the ground lost in their worst weekly fall since October, a decline attributed in part to hedge funds and other investors cutting back long positions as well as reducing short positions.
The bottom line, Emanuel said, is that options on GameStop and much of GameStop’s cohort of social-media-fueled speculative stocks “now have options that are very expensive, perhaps prohibitively so.”
