How did the stock rally fueled by Reddit and GameStop Options

Shares of GameStop began to take off on January 11, after the company stated that it had agreed to add three new directors to the board of directors and that the merger accelerated in the following days. In part, the gains reflect the popularity of the last few months of momentum trading, the practice of investing in companies whose shares are rising in the hope that they will continue to do so, and an increase over the last year in options, which allows users to place large bets with a relatively small initial investment.

How are the options in this?

Options are contracts that allow investors to buy or sell shares at a specified price, either up to a specified expiration date. They have become increasingly popular with small investors in recent years as brokers have made it cheaper and easier to trade them. The trading volume of options set a record last year, averaging just under 30 million contracts a day. This year, that figure exceeds 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 starting point for traders who exchange business ideas and accumulate in hot stocks.

How do GameStop traders use options?

The options come in two colors: call options, which give you the right to buy shares on specific terms, and options give you the right to sell them. Calls are especially popular among WallStreetBets people because buying them is a cheap way to bet on a rise in stocks.

Take market share on Tuesday, for example. GameStop closed at $ 147.98 per share. At the time, call options that allowed investors to buy GameStop shares at $ 200 for Friday were trading at about $ 19 per share, a fraction of the cost of an actual stock. If you bought this option and GameStop met, it would increase the price of your option and you could probably sell it for quick profits. If you have real GameStop shares, you would also benefit from the concentration, but you probably won’t get as great a return as you would with calls.

Alternatively, the use of options can help reduce 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, say, $ 100 per share. That way, if GameStop falls below $ 100, you can exercise your selling options, compensating for stock losses.

Why do stocks increase if the stock is in options?

When you buy a call option, someone else has to sell it to you. Typically, it is a market maker: an e-commerce 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 are not engaged in long-term betting on corporate prices. Therefore, when such a company sells you a GameStop purchase option, the market maker generally hedges that risk through a separate transaction. He will often buy GameStop shares.

In options language, this is called delta hedging, which is why intense buying of call options can increase the price of the underlying stocks. In addition, as the stock price approaches the level at which call options can be exercised ($ 200 in the previous GameStop example), market makers may intensify their stock purchases to maintain a neutral position.

According to data provider Trade Alert, GameStop options trading volumes have exploded over the past two weeks. For most of last week, calls were traded more actively than sales, a sign that investors were generally more bullish than bearish in stocks. Two executives with options manufacturing companies said delta coverage had played a role in recent hot stock concentrations like GameStop.

In extreme cases, this can become a personal reinforcement mechanism, as day traders buy more calls and drive market makers to buy stocks, raising the price of stocks and encouraging more traders to take action.

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

What do the experts say?

The scale and pace of the rally at GameStop, BlackBerry and other actions this year have surprised Wall Street by surprise and no one knows how long the gains will continue or which companies could get caught up in next year’s frenzy.

But industry veterans warn that a concentration on stocks based on the buying of speculative call options by small investors will inevitably crash, for a handful of reasons. Among them: many of these companies were subject to business tensions even before rising stock prices that drastically increased their valuations. Valuations and fundamentals tend to be closely related to the passage of time, analysts say, and higher valuations often mean stocks are prone to sharp declines.

Investors who buy their call options at the beginning of the rally and then leave before it ends will reap profits, possibly quite nice. Many already do, judging by Reddit posts, and one user claims to have made more than $ 11 million in negotiations with GameStop calls.

But buying later in the frenzy when prices are already high means taking on extraordinary levels of risk, traders say. Many buyers will end up with expensive call options that offer value quickly and will expire without value. Meanwhile, rising stocks are likely to put investors with more pockets back in the investment to bet on them. As the crowd engaged in day trading shifts to other stocks, the boom that fueled the three-digit gains is likely to burst, traders and portfolio managers warn.

“Finally, a bigger bully arrives,” said Stino Milito, co-chief operating officer of Dash Financial Technologies, an options brokerage firm. “You have big guys who say,‘ That’s ridiculous. This cannot continue. “

Write to Alexander Osipovich to [email protected]