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How Options Trading is Fueling the GameStop Rally

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The recent meteoric rise in shares of brick-and-mortar video game retailer GameStop Corp (GME - Free Report) has been one of the most interesting stories so far in 2021. GameStop shares had spent the previous five years drifting steadily lower even as the broad markets made impressive gains.

The increasing ease with which video game enthusiasts could download games to play - rather than purchasing hard copies from a store - seemed to portend a slow slide into irrelevance if the company didn’t change course. The share price had slipped from around $30 in 2016 all the way to near $3 last Summer - before a large number of retail investors began to buy the shares in concert, pushing GameStop back above $17/share on January 8th.

Professional investment firms that specialize in short selling took notice of an apparent lack of improvement in the fundamentals that would justify the rally and established short positions that eventually grew to more than 100% of the shares outstanding.

A massive game of financial “Chicken” was afoot.

On January 11th, GameStop announced that Chewy (CHWY - Free Report) founder Ryan Cohen would assume a seat on their Board of Directors. Through his investment firm, Cohen had already built a stake of more than 10% of GameStop’s outstanding shares and his addition to the board signaled the possibility of an impending turnaround at the beleaguered retailer.

The share price exploded over the next several days, hitting $35 by the end of that week, and $65 by the end of the following week. For a stock to double, triple and quadruple in such a short period of time generally means a short squeeze is occurring – especially in the absence of any significant news.

Short selling can be a very lonely and angst-ridden enterprise. Unlike a trader who takes a long position and who’s losses are limited to the amount invested, even in a worst-case scenario, the short-seller can lose a big multiple of what he initially stood to gain.

A trader who sold GameStop short at $17/share had the potential to make a maximum of $17 if the company was totally wiped out and equity shares became worthless. When they traded $65, that trader was sitting on losses of $48/share – and it still could (and did) get much worse.

On Monday, GameStop shares rallied all the way to $159.18/share intraday before being halted for volatility. When they reopened, they dropped sharply and ended the trading session at $76.74 before rallying hard again on Tuesday, trading up to $150/share once again.

The mechanics of a traditional short-squeeze are fairly easy to understand. When there are a large number of traders with a short position in a given asset and the price starts to rise, they need to cover their shorts by buying back shares to avoid potentially unlimited losses. If the longs aren’t willing to sell and new shorts can’t borrow shares to establish a new position, the price of the asset rises rapidly.

In the case of GameStop, there’s another factor at play that seems to be causing some of the (primarily upward) price volatility – the options markets.

A large number of the retail traders who are communicating on Reddit and other online forums and buying up the shares of heavily-shorted stocks like GameStop – as well as Bed Bath and Beyond (BBBY - Free Report) and Blackberry (BB - Free Report) – are using call options to establish long positions.

A trader who buys 100 shares for $80 each needs to shell out $8,000 to fund the purchase and faces the potential of losing that entire amount if the share price goes to zero. That same trader can buy a short-term out-of-the-money call option for about $10, limiting maximum risk to just $1,000, but also participating in a rally to the upside. That’s an attractive proposition for someone who has a significant portion of their investible assets in a single trade.

Larger traders might also be willing to risk the entire $8,000, but find the options markets an efficient way to add leverage - buying eight calls and controlling 800 shares instead of just 100.

So who sells the calls to these opportunistic traders during a parabolic rise in the price of the underlying shares? Typically a professional market-making firm. These traders are well-capitalized and are willing to provide a two-sided market for options, allowing individuals to buy or sell at any time. In return, they collect a bid-ask spread which tends to get much wider during periods of extreme volatility.

In general, the market makers aren’t interested in making a bet on the direction of future movements in the underlying, so they “hedge” their trades by making an offsetting trade in the stock itself.

If that $10 call that a retail investor bought has a 25% delta – meaning that it’s price will increase by 25 cents for every dollar the underlying stock increases – the market maker will buy 25 shares of stock after he sells the call. If a public order buys 100 calls, the market makers who sell will collectively buy 2,500 shares. So buying calls has much the same effect on the market price of the stock as if the investor simply bought the shares outright.

(Even though delta is expressed as a percentage, it’s common for traders to refer to an option like this as simply a “25 delta” – leaving off the “%” part.)

The influence of options trading doesn’t end there however.

That option won’t stay at 25 delta forever. If the shares rally significantly and that call is now at-the-money, it will have a 50% delta. To remain delta neutral, the market maker has to buy an additional 25 shares per short call. The exact timing and price of this adjustment to the hedge will vary based on the risk-tolerance of the individual market maker.

If the stock subsequently sinks back to the original price, the delta drops as well and the market maker will have to sell shares back out to maintain delta-neutrality. If the market maker needs to borrow shares to sell and they’re hard and/or expensive to borrow, it will have the effect of lowering the price at which he is willing to sell, and also raising the price at which he would be willing to sell more options.

It’s easy to see that if the market makers are net short options that they have sold to the public, their re-hedging activity will serve to exacerbate big moves in the underlying stock – in both directions.

There’s a positive feedback loop at work in these hyper-volatile and heavily shorted stocks. (“Positive” from the perspective of increasing volatility, not necessarily for the account balances of those involved.)

Volatility begets more volatility; the more a stock moves, the greater the demand usually is to own options with the potential to profit from those movements.

In short, don’t expect the wild ride in GameStop to end anytime soon. Once a situation like this gets started, it can often be quite a while before the share price settles down and the dust settles.

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