The broad markets have been somewhat volatile lately, but a handful of stocks have really been moving, primarily as a result of the so-called “Reddit” trades in which a group of retail traders uses an online forum to discuss the merits of companies they believe to be undervalued, then buy the shares and call options en masse to push the price up.

(This phenomenon is alternately referred to as the “Robinhood” trade – after the preferred trading platform of many small investors.)

Often, the targets of the Reddit crowd are stocks that have been heavily shorted and are therefore susceptible to quick spikes in price. The Reddit traders simultaneously buy up both the shares and out-of-the-money calls, creating a dynamic in which institutional investors who are short the shares are buying to cover at the same time that option market makers (who sold those calls) are buying additional shares to re-hedge their deltas.

It works…until it doesn’t.

Share prices can’t go up indefinitely. Eventually, there isn’t enough cash around to keep pushing them higher and every sell that fails to find a buyer at the current price pushed the price back down.

A quick trade that takes advantage of a mechanical aspect of the markets and makes profits when others are forced to cover is a smart idea. The concept that you can keep pushing the price of a stock (or any asset) infinitely higher simply by buying and refusing to sell is foolish. “Foolish” in that it literally relies on a belief that a greater fool will purchase the asset someday at an even more absurd price.

So if someone is behaving irrationally, there must be a way for a more sensible person to profit from it, right?

Well yes, but it’s trickier than it sounds.

The effect of the Reddit trades on option prices is often profound. With implied volatilities well into the triple-digits during the big moves in the underlying, vast sums of money change hands in the options markets – it’s a risky place.

On March 4^th, GameStop (GME Quick QuoteGME - Free Report) and Apple (AAPL Quick QuoteAAPL - Free Report) happen to be trading at almost the same share price. Of course Apple is a much bigger company overall with a $2 trillion market cap to GameStop’s $8 billion, but the similarity in price allows us to compare options prices more or less directly.

As one of the world’s largest and most stable companies, Apple shares tend to move slowly and predictably. It’s range YTD has been between $121 and $143/share and the average daily move is between 1-2%. As a major component of all the broad large-cap indices, Apple enjoys huge institutional ownership that ensures deep liquidity. Even after significant news events, there tends to consistently be sizable interest in buying or selling large quantities of shares at or near the current price.

Here’s a look at the at-the-money options with 15 days remaining to expiration. ATM implied vol is around 40% - high for Apple recently after a broad selloff in Technology shares - but with a straddle price that’s still only around $8 dollars.

Here are the options for GameStop with the same expiration:

Implied vol is over 300% and the straddle is $60 dollars!

A buyer would need the stock to move 50% over the next two weeks just to break even, but also keep in mind that a seller is betting that the shares won’t move much – even though most covering analysts think the stock is objectively “worth” between $10 and $20/share based on the fundamentals, but that it also rallied 175% between February 23^rd and March 3^rd.

The message boards are full of screenshots of profitable positions in which someone bought options for a tiny amount and is now sitting on huge accumulated profits. That looks exciting and makes enormous gains appear within reach, but keep in mind that to even have a chance at a trade like that, you probably have to lose the entire premium on an option purchase hundreds or thousands of times.

It’s the equivalent of a lottery winner posing with an oversized cardboard check depicting the winnings – it’s not a good argument for buying lottery tickets.

The high IVs of the Reddit stocks mean dramatically higher stakes in options trades that involve simple buying or selling.

The more sensible move is trading volatility-neutral strategies like vertical spreads, butterflies and condors - or the "iron" versions of these trades.

While you may be eliminating the chances of making a huge percentage profit on a given trade, you also eliminate the possibility of taking a huge loss and skew the probability of small wins in your favor.

While many traders view options as a way to employ leverage to swing for the fences , the odds are good that they end up losing most or all of their capital eventually. Those who buy and sell equal numbers of options – especially when implied volatilities are sky-high – enjoy long and profitable trading careers.

-Dave

David Borun runs the Zacks Marijuana Innovators Portfolio as well as the Black Box Trading Service and the Short Sell List Trading Service. Want to see more articles from this author? Scroll up to the top of this article and click the “+Follow” button to get an email each time a new article is published.

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