There is an old saying among commodity traders that the remedy for high prices is high prices. The same will probably be true for the options on GameStop Corp. and other flight targets that have become popular on Reddit message boards, said a veteran options analyst.
The idea is just Econ 101: as prices for wheat or oil or gold rise too much, users naturally use less of the product. As demand rationalizes, prices eventually fall (the same idea works the other way around, with low prices seen as a cure for, you guessed it, low prices).
And so it could go after last week’s frantic buying of call options, which gives the holder the right, but not the obligation, to buy the base title at a set price until a certain time, on GameStop GME,
and the shares of other companies with strong short circuits, Julian Emanuel, chief strategist of shares and derivatives at BTIG, said in a note on Sunday.
The heavy buying of calls was part of an effort by an army of individual investors organized through the RedSit WallStreetBets forum to raise the prices of short-circuited companies, forcing failed sellers to buy back their shares and speed up the rally. Buying calls generated its own feedback loop, as market makers, who sold the call options, bought the underlying shares to hedge or neutralize their market exposure.
More details: How an options trading frenzy raises stocks and raises fears of a market bubble
The strategy, as anyone who pays the least attention to last week’s markets or news, seems to have worked out pretty well. GameStop shares rose 400% last week to close at $ 325 on Friday, after hitting a high of nearly $ 500 on Thursday. GameStop ended in 2020, almost $ 18 per share.
Read: GameStop short squeeze feeds new stock services that track Reddit messages
Given these fluctuations, the default volatility – a measure of the cost of an option – at a minimum of 1,000% proved to be cheap for options that expired last week, Emanuel said, noting in the chart below the increase in volatility achieved in 3 days.
BTIG
But it will probably be a different story in the future, he said, arguing that the options “have probably become too expensive to remain a source that fuels even more of a few meteor winners.”
To illustrate, he mentioned that a money call option (one with a sale price equal to the share price) on GameStop that expires on February 19 cost about half of the actual GameStop share price, or 580% volatility. By comparison, the call for the S&P 500 SPX,
also expired on Feb. 19, costing 2.5 percent of the actual index price or volatility of 26.5 percent, he said.
Since both options were for money, they did not have “intrinsic value”, a measure of the profitability of the option based on the strike price in relation to the share price. Instead, premiums consisted entirely of ‘time value’, based on the expected volatility of the underlying asset and the time to expiration of the option.
GameStop shares fell 27% Monday, while Dow Jones Industrial Average DJIA
it rose 300 points, or 1%, and the S&P 500 advanced about 1.8%. Major benchmarks took over some of the ground lost in the worst weekly fall in October, a decline attributed in part to hedge funds and other investors, reducing long positions as well as reducing short positions.
The bottom line, Emanuel said, is that GameStop options and much of the GameStop cohort of social media-fueled speculative stocks “now have very expensive, perhaps even prohibitive, options.”