Earlier in 2021, we saw some pretty incredible trading in the shares and options of video-game retailer Gamestop (GME Quick QuoteGME - Free Report) when the stock went from $10/share all the way to $483, fueled by the trading of the Reddit community in Wallstreetbets who correctly sniffed out big short interest and then caused (or simply exacerbated) a short squeeze.

After falling back to the $40 level, Gamestop shares have risen all the way back to over $280 recently. It’s no longer the hottest stock with the meme-traders, however. Right now that title belongs to the shares of movie theater operator AMC Entertainment (AMC Quick QuoteAMC - Free Report) .

Starting the year at $2 and rising all the way to $20 during that Gamestop rally in January, AMC shares mostly flatlined for the next few months before starting another steep rise.

On Wednesday, AMC shares nearly doubled in a single session, rising 95% to close at $62.55.

Trading volumes are huge. 50-100% of the float of AMC is trading hands each day lately – a clear indication that there’s more than simply a short squeeze at work here.

Options volumes are even more incredible. On Wednesday 4.6 million AMC contracts changed hands. That’s more than 10% of all the 42 million equity options traded in the entire market!

Implied volatilities are unbelievably high. June options traded near 500% IV on Wednesday. Similar to a situation we saw in Gamestop earlier in 2021, buyers of the 46-day at-the-money 65 strike straddle were paying $65. At that price, a seller has no downside risk (because the shares can’t go below zero) and only loses on the upside if the stock more than doubles in value.

With those kinds of share price moves and premium levels, you might be considering diving into the AMC options market.

Before you do, let’s reconsider the concept of “gamma squeeze.” It’s what happens when traders buy a large number of calls on a stock that’s rising.

A trader who buys 100 shares for $62 each needs to shell out $6,200 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 $6,200, but find the options markets an efficient way to add leverage - buying six calls and controlling 600 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.

If trading in Gamestop in January is any indication, AMC shares are going to remain volatile – and implied vols are going to remain high until the majority of the open options positions are closed, or more likely – expire.

If you’re going to go for it, be careful. Define all of your risks and decide ahead of time where you intend to exit your trades to avoid the trading paralysis that can occur when you're staring at a big, unexpected profit or loss.

-Dave

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