Our Low-Risk GameStop Trade
You have undoubtedly watched the meteoric rise of GameStop (NYSE: GME) over the past few weeks and thought “I wish I had a piece of that.” I won’t get into the reasons for GameStop’s rise, nor will I speculate on how quickly it might come crashing back to earth.
Maybe by the time you read this the share price will have already made a large correction, but as I write this GameStop closed the trading day at $347.51. That marked a gain of 138% for the day.
As a digression, GameStop’s surge provides a perfect example of why I never, ever short a stock. I never want to be in a trade where the potential losses are unlimited, and that is the case when shorting stocks. Short sellers of GameStop, including hedge funds, have racked up massive losses in the past few days. Further, they won’t likely have the opportunity to ride out those losses, as margin calls will cause many positions to be liquidated.
The thesis for shorting GameStop was pretty sound. You could make a strong case for why the company’s business would continue to decline. But market psychology can be a tremendous force that drives a stock in a direction opposite of where the fundamentals might suggest. That appears to be the case here.
I wouldn’t recommend trying to hop on the GameStop train. I don’t know if a week from now it will be a quarter of its current value or three times the current value. It opened the year, just four weeks ago, under $20. Just a couple of days ago it was $65, and a widely read article on Seeking Alpha called for shorting at that level. If you followed that advice, you have my condolences. At one point you would have been down more than $400 a share on that trade.
But there is a low-risk way to profit from this kind of volatility. In times of extreme volatility, sometimes you will see option values that really don’t make a lot of sense. Money can be made in times like this.
A put option obligates the seller to buy 100 shares of a stock if it’s value is below a defined level at a specified future date. It is the opposite of a call option. The person who buys the put is trying to lock in their profits at a certain level. For example, if you own GameStop at today’s close, you might want to see how far it might go, while buying “insurance” against a total price collapse. In that case, you could buy a put option.
But GameStop’s put options got very expensive. This is an indicator that many people expect the value to fall, so they are buying puts. At today’s close, if you wanted to buy a put with a strike price of $300 and an expiration date of April 16 (79 days from now) it would have cost you $195. To me, it’s insane to think of paying a premium that high to protect that gain.
So let’s sell one instead. Let me walk you through what I did. Incidentally, I don’t share my trades to boast about making a good trade. I won’t know for months whether this was a good trade. Instead, I share them to highlight attractive risk/reward propositions, and to just share my thinking in searching for profitable trades. This might still be an attractive trade with GameStop when this article publishes, but if not there will be others.
GameStop’s closing price on the first day of this year was $17.25 a share. Since the $300 puts were so expensive, I suspected that the puts at far lower strike prices would also be richly priced. So, I checked several combinations, and found that puts expiring in November with a strike price of $17.00 were trading for $6.50 a share. Selling a put (again, representing 100 shares) netted me $650 per contract, but it obligates me to buy GameStop shares for $17.00 on November 19 if shares are at or below that level. That is the risk, but it is a defined and finite risk.
If I am assigned, my net price will be $17.00 per share minus the $6.50 per share premium I received for selling the put. Thus, my net cost in the case of assignment is $10.50 per share, or $1,050 per contract.
Because shares could be assigned, I want to have $1,700 in my brokerage account for every put contract I sell. (You can get by with less, but under no circumstances do I recommend using the margin in your account for trades like this.) The potential return per contract is $650/$1,700, or 38.2% in under 10 months.
Shares will have to decline by 95% to be at $17 in November. Could that happen? Sure, it could. Shares have been as low as $2.85 in the past year. But short sellers are going to be pretty wary of this company going forward. Further, the share price was above $17.00 before the sharp rise, so it seems like a reasonable bet that 10 months from now it will still be above that level. If so, I earn 38.2%.
But it’s not risk-free. If shares are below $17.00 at expiration, I still have to pay $17.00 for the shares. Because my net cost was $10.50, if shares fall below that level I will lose money. So, I will have zero profit at $10.50 and maximum profit at $17.00 or above.
The most I could possibly lose is $1,050 per contract, but shares would need to decline all the way to zero for that to happen. A finite maximum loss is one thing that makes this very different from short-selling. Further, I am rooting for GameStop’s success. The only way I lose on this trade is a spectacular collapse from the current value. I fully expect a steep drop in the share price from the current value, but I am making a calculated bet that it won’t be all the way down to $17.00 in November.
It’s like getting money for nothing. Time will tell. There is a risk, but I like my chances.
Editor’s Note: As our colleague Robert Rapier just explained, the GameStop drama has roiled the broader market and highlighted market vulnerabilities (and opportunities).
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