GameStop (NYSE: GME) showed us exactly why I love trading options … but also how dangerous it can be.
By now, we’ve all seen what happened to GameStop — a short squeeze of epic proportions.
The stock exploded — its price rose more than 1,000% in just a few weeks.
During the frenzy, many people were tempted to jump in and bet on a pullback.
We’ve cautioned against getting in on the downside the traditional way. You never want to short a company — it exposes you to too much risk.
Buying options is better, but we don’t recommend that today, either. After the surge in GameStop earlier in the week, the implied volatility of the options made it not worth trading them — and it’s still that way right now.
Let me show you how smart traders are profiting from this chaos…
Buying Puts Isn’t Worth It Just Yet
Options are my favorite way to trade any move in a stock, up or down. But there are times when we simply have to pass.
After GameStop’s massive rally, we knew shares would come tumbling back to Earth. It’s the classic short squeeze situation: A company with weak fundamentals pops on no news, then plunges back down in quick fashion.
You may have thought about buying a put option and benefitting from the expected decline.
If you peeked in on the options after the rally, you’d notice they weren’t cheap. Not just in terms of dollar amount per contract, but related to the strike price.
On Wednesday this week, with the stock trading just under $100 a share, options prices still weren’t worth buying.
The $100 strike price was costing you a 45% premium for just a month and a half. That’s what implied volatility means. A 5% premium would be reasonable, or $5 for the $100 strike price. But 45% means we are seeing extreme implied volatility in the options market.
For that 45% premium to be profitable when the option expires, the stock would have to be under $55 a share, a 45% move in the stock. To double your money, the stock would have to fall to $10 a share, $90 from where it was on Wednesday.
If it was a 5% premium, then the stock would just need to be below $95 a share to see profits. And you would double your money if it falls to just $90 — 10% lower.
You can see why we want to avoid a high amount of implied volatility in this stock.
The market is pricing in a move of at least 45% for GameStop. If the stock doesn’t drop right away, you’ll risk losing money until shares plunge 45% during the next six weeks. Clearly, it’s possible. But it’s not the smart way to bet on a decline because it is taking unnecessary risk for what would be a modest profit.
I took a totally different approach to take advantage of this rise in implied volatility.
My goal was to simply look for the highest probability of locking in a double-digit profit over the next couple of months. I’m not shooting for the stars here. Just looking to scalp a nice 15% profit with an extremely high probability of paying out.
Here’s what we did…
Taking the Other Side — Selling Puts Into This Frenzy
The high cost of the option is reflecting the implied volatility of the underlying stock. The market is expecting this stock to be on the move a lot over the next few days, so anyone trading options has to pay up.
Well, you don’t always have to buy options.
In times like this, it’s best to sell options instead, and collect the increased premiums.
I’ve talked about selling put options before, all the benefits and the extremely high win-rate it helps me generate.
But I was even more confident about this trade.
In my Pure Income service, we look to sell options on stocks to collect income … while we promise to buy stocks if they fall to a price we would want to own them at anyway.
We essentially told the market we would buy GameStop if it fell 97% between now and April 16. That was where we picked a strike price. And in return, we got paid the premium— 16%.
We turned the extremely high implied volatility in the options market into our benefit. Selling options helped set us up for a potential double-digit profit with ease.
Shorting a stock carries too much risk. And buying puts on GameStop was too expensive at the moment. So, we flipped this trade and sold put options, where we can get paid to wait for the stock to fall.
That’s why I recommended this trade to my readers.
Many were able to jump into this trade despite some brokers setting limits on trading GameStop. Now that we are in, it’s one I expect to be a double-digit gain for us in Pure Income.
Strategies Like This Can Boost Your Portfolio
Now, I don’t pretend I know what stock will jump into a frenzy next, or how we’re going to play it. But I’ve developed strategies throughout my career here at Banyan Hill that help my readers profit from swings in the markets — whether they’re to the upside or to the downside.
And in 2021, I’m doing something new. I’ve partnered with my colleague Charles Mizrahi to bring a special offer to you. It’s launching on February 23.
We can’t tell you all the details yet, but I promise you, you’ll want to be one of the first to see it. You can sign up to get updates on when we launch, how you can make these trades and how you can get early access.
That’s all for today.
Next week I want to talk about how important the “expected move” is in options. When you look at implied volatility, it’s always related to the expected move.
If you think GameStop will drop 90% in the next few weeks, then paying a 45% premium for the $100 put option may be worth it. But not for me. I have a simple rule of thumb we’ll follow to make sure it’s worth buying an option.
More on that next week.
In the meantime, if you have any topics you’d like covered in our Weekly Options Corner you can send them to WeeklyOptionsCorner@BanyanHill.com.
Chad Shoop, CMT
Editor, Quick Hit Profits