Shares of a handful of companies such as GameStop Corp.
GME 92.71%
and BlackBerry Ltd.
have posted triple gains in recent weeks, part of a frenzy sparked by individual investors. Here’s What You Should Know.
GameStop’s stock will have increased more than sevenfold by 2021, compared to a 2.5% increase in the S&P 500. The video games vendor in Grapevine, Texas, has become a favorite of online merchants investing in companies defended on the Reddit forum WallStreetBets.
These investors are targeting short sellers who bet the stock will fall because of what they see as the company’s business challenges. The basket of Goldman Sachs Group Inc. Of the 50 stocks with the highest short-term interest rates – Wall Street bets the stock will fall – 25% was up over the year through Friday. Rising prices in high short stocks, such as GameStop, have resulted in large losses for hedge funds betting against stocks, prompting a $ 2.75 billion emergency deal to save such a company.
GameStop shares started to rally on January 11, after the company pledged to add three new directors to the board, and the rally accelerated in the days that followed. In part, the gains reflect the popularity of momentum trading in recent months, the practice of investing in companies whose stock prices are expected to continue to rise, and an increase over the past year in options trading, pushing users make big bets with a relatively small upfront investment.
How do options play in this?
Options are contracts that allow investors to buy or sell shares at a specified price, either on or until a specified maturity date. They have become more and more popular with retail investors in recent years as brokers have made it cheaper and easier to trade them. The trading volume of options hit a record last year, averaging just under 30 million contracts per day. This year, that number 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 a hotbed for day traders trading ideas and piling up in hot stocks.
How are GameStop traders using options?
There are two types of options: call options, which give the right to buy shares under certain conditions, and put options, which give the right to sell them. Calls are especially popular with the WallStreetBets audience because buying them is 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 the time, call options that allowed investors to buy GameStop stock for $ 200 each by Friday were trading for about $ 19 a share – a fraction of the cost of an actual stock. If you were to buy such an option and GameStop would go up, the price of your option would go up and you could probably sell it for a quick profit. If you had actual GameStop stock you would also benefit from the rally, but you probably wouldn’t get as big a return as you would with the calls.
Alternatively, using options can help reduce risk to investors. For example, if you buy GameStop stock, you can protect your portfolio by buying put options that allow you to sell GameStop for, say, $ 100 per share. That way, if GameStop falls below $ 100, you can exercise the put options and offset your losses on the stock itself.
Why do stocks rise when the action is in options?
If you buy a call option, someone else has to sell it to you. Typically, that’s a market maker – an electronic trading firm that buys and sells stock, options or other assets all day long, such as Citadel Securities LLC or Susquehanna International Group LLP.
Market makers are not about placing long-term bets on company stock prices. So when such a company sells you a GameStop call option, the market maker typically hedges that risk through a separate trade. It will often buy shares of GameStop.
More about GameStop’s Rise
In options jargon, this is called delta hedging, and therefore heavy buying 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 can increase their stock purchases to maintain a neutral position.
Trading volumes of GameStop options have exploded in the past two weeks, according to data provider Trade Alert. For most of the past week, calls traded more actively than put, a sign that investors were generally more bullish than bearish for the stock. Two executives with options market-making companies said delta hedging had played a role in the recent rallies of popular stocks like GameStop.
In extreme cases, this can become a self-perpetuating mechanism, with day traders buying more calls and prompting the market makers to buy shares, boosting the stock price and encouraging more traders to take action.
“It can take on a life of its own,” said Steve Sosnick, chief strategist at Interactive Brokers.
What do the experts say?
The size 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 which companies could get into the next frenzy.
But industry veterans are warning that a stock’s rise based on speculative purchase of call options by small investors will inevitably collapse, for a handful of reasons. Among them, many of these companies were under pressure even before rising stock prices spiked their valuations. Valuations and fundamentals are closely linked over time, analysts say, and higher valuations often mean stocks are subject to sudden falls.
Investors who buy their call options early in the rally and then exit before the top comes out will benefit, possibly quite well. Many have already done so judging by Reddit posts, with one user claiming to have made more than $ 11 million in GameStop calls.
But buying later in the frenzy when prices are already high means taking extraordinary risks, traders say. Many buyers will eventually have expensive call options that lose value quickly and are likely to expire worthless. Meanwhile, rising stocks are likely to put deep-pocketed investors back in the fight to bet against them. As the day trading public shifts to other stocks, the boom that fueled triple-digit earnings is likely to break, warn traders and portfolio managers.
“Ultimately, a bigger bully comes in,” said Stino Milito, co-chief operating officer at Dash Financial Technologies, an options brokerage. ‘You get big guys saying,’ This is ridiculous. This cannot continue. ”
Write to Alexander Osipovich at [email protected]
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