When a Volatile Stock Behaves Like an Option
In recent days stocks like GameStop (NYSE: GME) and AMC Entertainment Holdings (NYSE: AMC) have become battlegrounds for retail traders against institutional traders. Due to the huge day-to-day price swings and media coverage, even people who normally don’t actively trade stocks are getting involved, hoping to make a quick profit from the wild fluctuations.
I expect those stocks to eventually fall hard back to earth, but in the short run they can defy gravity. The action is so detached from underlying fundamentals of the companies that trading them is like betting on a roulette wheel. No matter how these stock moves play out, they’ll likely go down as cautionary case studies in future finance text books.
Normally, to aggressively go after faster and bigger percentage gains, you can buy options. But in this case, the stock action has been so dramatic that the stock is moving more than the options.
If you held call options in GME or AMC before they took off, congratulations on your amazing percentage gains. However, if you bought puts or calls once the volatile action already started, your percentage gains would not be that impressive compared to the stock’s gains (see table).
The above table compiled by the Investing Daily staff shows the closing prices of the GME March 250 and March 300 calls and puts on the dates indicated. GME’s closing prices are also listed for comparison. Note that the calls listed had zero trading volume until January 27 because before that date GME was so far below those strike prices, no one bothered to trade them.
Note, too, that even buying one option contract would cost five figures. For example, one contract of the March 300 call at the 1/28 closing price of $110.37 would still cost $11,037. By contrast, given the huge swings in the stock, you could have risked less money to buy the stock itself and still enjoyed the option-like price movement. Plus, a stock doesn’t have an expiration date like an option.
Need Big Fluctuations
Put another way, if you bought the March 300 call at $110.37 and held it to expiration, you would need GME to be at least $410.37 at expiration just to break even. On the other hand, if you bought the March 300 put on 1/28 at $198 and held that to expiration, you would need GME to fall to $102 at expiration to break even.
In reality, it’s highly doubtful many GME option buyers plan to hold a GME option for long, but the point is that as an GME option buyer you would need big moves in the stock price to be in the money by expiration.
Does that mean it would be a great deal to write GME options instead?
You would collect very nice premiums, but in light of the huge day-to-day moves of the stock, you do leave yourself open to potentially large losses. You could consider an out-of-the-money covered call, but such a strategy limits your potential upside. Since the reason you would buy GME is to speculate on huge gains, limiting your own potential may not be appealing to you.
Sky-High Implied Volatility
Why are the premiums for the GME options so expensive?
Not surprisingly, the reason is high implied volatility. This means that option traders expect large fluctuations in GME, whether up or down.
Since an option becomes worthless if it expires worthless, option buyers prefer to buy options on underlying stocks that have a strong potential to move. After all, if a stock doesn’t move very much, even if you are right about the stock’s direction, you could still lose money on the option trade. However, sometimes implied volatility becomes so high that buying an option may not make sense, as discussed above.
Editor’s Note: Our colleague Scott Chan just provided you with invaluable investing advice, but maybe options trading isn’t for you.
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