When most investors learn about the options markets for the first time, they tend to have the same first impulse – they want to buy calls. Most of the time, that impulse is wrong.

It’s understandable. The leverage aspect of long call options means that you get to participate in the upside profit when a stock (or other asset) appreciates and that your risk is limited if the stock declines instead.

Especially if you’re about to start trading with a relatively small amount of capital, owning calls could be a way to experience big profits quickly.

If you buy $1,000 worth of stock and it appreciates 10% in price, you make $100 in profits. That’s a nice percentage return, but it’s only 100 bucks.

If you instead buy $1,000 worth of at-the-money calls and experience the same 10% increase in share price, there’s a good chance you could make $1,000 or more in profits – doubling your investment.

Taking that logic one step further, let’s say you instead buy $1,000 worth of far out-of-the-money calls. Because they’re so inexpensive, you can buy a lot of them. If they’re trading for 25 cents each, you can buy a 40-lot. On the upside, you control 4,000 shares of stock. If the shares rise rapidly, there’s a chance that you could see a return of many thousand percent on your original $1,000, turning it into $10,000 or more.

It’s that type of turbocharged profit potential that’s causing many of the so-called “meme-traders” to make serious mistakes in the options markets.

Screenshots of massive call-buying profits have many of those traders clambering for (apparently) inexpensive calls, pushing those options premiums up to very expensive prices.

It’s most evident when a stock is rallying hard and you examine the open interest on the call with the highest available strike. In the options for the hottest meme stock of last week - AMC Entertainment (AMC Quick QuoteAMC - Free Report) – the June 145 calls are the highest listed strike. They also have open interest of more than 18,000 contracts. (The next eight lower strikes down to the 105s have much lower open interest between 400 and 1,200 each.)

When a significant amount of the trading activity is concentrated on the highest strike, it tells me that speculators are piling into the least expensive calls they can get - probably with little regard for the implied volatility they’re buying.

They supply/demand related price increase due to all of those buyers isn’t limited to that single strike, however. Because of an opportunity for arbitrage, the lower strikes have to rise in price as well.

(If you could buy the 140 call for a lower price than you can sell the 145s, you would be locking in a riskless profit.)

Last week, when the meme traders thought AMC was the next stock “going to the moon,” they were paying absurd prices for the high strike calls. At one point on June 3^rd   when the shares were trading around $50, you could sell the 140 calls for $11.85 each.

Right there, you’ve got to be intrigued by a premium of almost 12 dollars on an option that will be worthless if the underlying stock doesn’t rise more than 150% in the next 15 days.

If you had a really big tolerance for risk, you could simply sell those 140 calls. But if the shares were to stage that huge rally, your losses would mount quickly.

So I went looking for a way to get some of that juicy premium while mitigating some of that (theoretically infinite) risk.

The 70 strike calls were offered at $18.70.

I sold the 1x2 ratio call spread. I bought one 70 call and sold 2 140 calls and collected $5 in premium.

If the shares stayed anywhere below $70, I would simply keep the entire premium. If they rallied above $70, I would make even more money as my long call went in the money and appreciated, all the way to a maximum profit of $7,500 if the shares were exactly at $140 at expiration.

Even if the stock kept going higher, I’d still have some profit all the way up to a price of $215. Above that, I would start experiencing losses.

I almost never recommend entering any options trade with unlimited risk, but I made a rare exception in this case. I figured that the chances that a nearly-bankrupt company that had rallied from $10/share to $60 in a month probably wasn’t going to get above $215 in two weeks. – especially a company that was issuing 11 million new shares to take advantage of the opportunity to raise much-needed cash during the rally.

This week, I closed the trade for a credit, buying back those 140 calls for under a dollar each. I’m still holding the 70 calls, but I have been paid to own them - and I now have unlimited upside potential if AMC shares do stage an incredible (and highly improbable) rally over the next week.

I think there are two lessons here.

First, there are occasionally opportunities to make trades in the options markets where the odds of being profitable are significantly in your favor. They don’t happen very often, but they’re sweet when they do.

More importantly, if your strategy is to buy the cheapest available call in the hopes that a wild rally will turn you into an instant paper millionaire, there’s a good chance you’re flushing that money down the toilet.

-Dave

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