GameStop Craziness Trade

GameStop (GME) is not a growth stock, and it’s not a company in which I would ever invest. Everyone who’s into stocks has heard about GME by now, and it’s gotten much of the attention this week.

The Company

GME is a retailer of video games. With video game sales going mostly online, this brick and mortar retailer doesn’t have a bright future. At some point, GameStop will probably go out of business. At the start of 2021, GME shares were below $20/share, and they were probably worth less than that.

Hedge Fund Shorting

Recognizing that GME’s future is dismal and that the share will almost surely drop, some investors shorted the stock. In aggregate, investors shorted more than 100% of the floated shares. Thus, there were more shorted shares than actual shares. It’s interesting that it is even possible to short more shares than there are. It’s clearly a flaw in the system.

Unlimited Potential Losses

One problem with shorting a stock is that in theory a stock price has no upper limit so losses are potentially unlimited even though the underlying company may not be worth nearly that much. A second issue with shorting is that in order to sell short a stock one must first borrow the shares from someone who owns the shares. Then these borrowed shares can then be sold. The resulting short position of 100 shares of GME will show as -100 shares in the account of the short seller. The borrower of the shares must pay interest on the borrowed shares, and the interest rate gets higher and higher the more difficult it is to borrow shares as dictated by supply and demand. Thus, as the percentage of the floated shares increases, the cost of borrowing rises. In addition, the higher the percentage of short shares, the more difficult it is to find shares to borrow. As the share price rises, some shorts are forced to close their short positions which is the same as buying; this “buying” creates more demand for the shares and drives the share price even higher. It can snowball in a virtuous cycle called a short squeeze.

Reddit Users Target the Short Sellers

The users of Reddit led a concerted effort to squeeze the short sellers by buying shares of GME. The buying created demand which raised the price which pressured some of the short sellers to cover (i.e. buy back the shares they sold short) which raised the price further. It doesn’t matter than GME shares are worth less than $20/share. The supply and demand dynamic forced the share price up. Yesterday on 28Jan, GME shares traded as high as $483 and as low as $112.25!!! Eventually, the GME shares will trade what they are really worth which is likely going to be below $20. But in the meantime, who knows how high the shares can go and how wildly they may swing.

Opportunistic Options Trades

As I said, I would not normally trade on GME shares or options. But there was a pretty big opportunity created by the volatility of the shares. The premiums on options were astronomical so I took advantage.

On Wednesday 27Jan2021 when GME shares were at $320, the combined premium for selling an at-the-money straddle was a whopping $200!!! This premium was on options that were expiring two days later! I do not own shares in GME so my short options positions were naked. The following trade was made on 27Jan when the shares were at about $320.

• Sell to Open 1 contract 29Jan $320 call for $96.00/share credit
• Sell to Open 1 contract 29Jan $320 put for $102.50/share credit

With the craziness I did not want to hold these options overnight so I closed them near the end of the trading day on 27Jan.

• Buy to Close 1 contract 29Jan $320 call for $95.00/share debit ($1/share profit)
• Buy to Close 1 contract 29Jan $320 put for $84.65/share debit ($17.85/share profit)

On Thursday 27Jan2021 when GME was about $360, I entered into the ATM straddle again.

• Sell to Open 1 contract 29Jan $360 call for $105.74/share credit
• Sell to Open 1 contract 29Jan $360 put for $94.93/share credit

Shortly after my trade, GME share price blew past $400 so I decided to buy protection against losses from my naked put. The cost to buy protection was now reduced due to the share price increase. I bought the following put contract:

• Buy to Open 1 contract 29Jan $200 put for $19.00/share debit

Since the shares are not really worth more than $20, I was much more worried about the risk of the shares falling to their true value than the share price rising further. Also, a further rise in share price is ok as long as the price eventually falls back down: I would be able to keep rolling the naked call forward on a weekly basis.

When the news broke that some brokerage firms were restricting GME buying, I thought that the share price would not likely rise much further. Therefore, I felt comfortable holding my options position overnight. I had collected a net of $181.67/share in premiums and with the $200 put for protection, I would still end with a profitable trade even if the stock price went to zero. The only risk to my trade would be if the shares went above $540. So I held my positions overnight.

I closed all the positions in the middle of the trading day on 29Jan when GME shares were at about $335. There was still about $50 of time value remaining on the straddle, but I preferred to lock in my profit rather than risking that the shares might diverge further from my $360 strike price.

These GME options trades worked out. I think that the super high premiums that were offered provided an acceptable risk-reward situation for this trade. In fact, the shares would have had to move well over $500 to lose on the trade. GME will eventually be worth much less than their current price so I think the bigger risk to selling straddles is a complete share price collapse while the trade is on.

The opinions, thoughts, analyses, stock selections, portfolio allocations, and other content is freely shared by GauchoRico. This information should not be taken as recommendations or advice. GauchoRico does not make recommendations and does not offer financial advice. Each person/investor is responsible for making and owning their own decisions, financial and otherwise.