By: Dividend Sensei
In 2020 we saw historic volatility, including the fastest bear market in history. We saw some stocks soar by 2,700%. But 2021 has so far proven to be an even wilder time on Wall Street.
(Source: Business Insider)
- Last year Hertz went up almost 1000% in a week…after declaring bankruptcy.
- AMC (AMC) was recently worth 5X more than pre-pandemic levels, for a company at high risk of bankruptcy!
- Blockbuster (bankrupt)’s holding company jumped 700% on January 27!
- Due to small investor speculation via Robinhood and Reddit
- options are a hyper-leveraged way that retail investors are speculating and trying to earn fast fortunes
- but can experience 100% losses in a matter of hours
To understand why these stocks are rising and falling by 50% or more in a single day, we have to first understand the mechanics of speculation.
Options And Massive Leverage Are Driving Some Of The Craziest Price Action In History
Gamestop is part of a perfect storm of speculative mania caused by two things seldom seen by most investors.
- short squeeze
- gamma squeeze
Gamestop, before WallStreetBets, began its short squeeze campaign, had 140% short interest. How can 140% of a stock’s shares be out short? Because of options, which allow even small retail investors to make highly leveraged bets on short-term stock price movements.
This brings us to the causes of some of the wildest price swings seen in recent weeks.
When hedge funds like Melvin Capital short a company like GameStop they have to borrow shares from those who already own the stock. They pay an interest rate determined by supply and demand (recently as high as 80% per year at some brokers).
If the stock falls quickly, then these shorts cover by buying back the shares, returning them to their owners, and profiting a modest amount that is hopefully impressive in annualized terms.
- max short profit is 100% minus interest cost to borrow shares
Options are how speculators can crank up the risk and potential reward to 11.
- naked options can allow you to bet for or against a stock with leverage
GME February 2021 Call Options
(Source: Yahoo Finance)
- for $3,355 per contract you can buy the right to sell 100 shares of GME for $800 by February 26th
- if GME were to rise to $1,000 by February 26th then that call is $200 in the money.
- Meaning it’s worth $20,000 and earns you a 500% return…in less than a month
- or if GME closes below $800 the contract expires worthless and you lose 100%
- if GME closes below $833.55 but above $800 you lose some of your money but not all of it
If you want to bet against GME the opportunity for speculative profit is even greater.
(Source: FactSet Research Terminal)
Say you believe that analysts are right and GME will fall back to $13. Except that instead of 12 months, you think it will happen by February 26th.
If you want to gamble that GME’s bubble will burst in historic fashion, then take a look at these put options.
GME February 2021 Put Options
(Source: Yahoo Finance)
- For $8 you can buy the right to sell 100 shares of GME for $3 by February 26th.
- If GME were to fall to $1 then those contracts are $2 in the money.
- Worth $200 each vs $8 cost basis
- 3,125X leverage!
- 25X your money in less than a month
- an example of deep out of the money/lottery ticket style gambling
There are some people who were able to make 10, 20, even 100X their money in a few weeks. Some people made 1,000X their money in a few years, with longer duration LEAP calls.
With profit potential like this, you can understand how new investors, flush with stimulus checks and able to trade options commission-free on Robinhood might get carried away with champaign wishes and caviar dreams.
But That Doesn’t Mean They Can’t Get Even Bigger
I'm an Army veteran and former energy dividend writer for The Motley Fool. I'm a proud co-founder of Wide Moat Research, Dividend Kings, and the Intelligent Dividend Investor. My work can be found on Seeking Alpha, Dividend Kings, iREIT, and the Intelligent Dividend Investor. My goal is to help all people learn how to harness the awesome power of dividend growth investing to achieve their financial dreams and enrich their lives. With 24 years of investing experience, I've learned what works and more importantly, what doesn't, when it comes to building long-term wealth and income streams and achieving long-term financial goals.
March 1, 2021