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GameStop’s Huge Squeeze Sets Up an Intriguing Bullish Options Trade

Quick question: In July of 2021, do you think GameStop (NYSE:GME) stock will be trading above or below $20 per share? For a quick hint, shares are currently trading around $245. Furthermore, GME stock has been at or above $20 for all of 2021. It spent only a few days below $40, in fact.

A Gamestop video game store in the Herald Square shopping district in New York
Source: rblfmr / Shutterstock.com

Yet, in the options market, there’s a way to make a healthy return simply if the stock stays above $20. That’s even though GME stock only crashed back to $4o or so even at the depths of its February pullback.

In any case, here’s a great way to profit from GME’s stock price staying relatively elevated, even if shares descend sharply from their current triple-digit levels.

Some Traders Think GME Stock Will Drop 93% Soon

Back to the opening question: What odds do you place on GME stock being under $20 within four months? Pretty low, right? Yet, people are currently paying $2.00 per option contract to bet on GME stock dropping below $20 by July of this year. If you think GameStop will stay above $20, you can take advantage of that fear and sell $20 naked put options to the hyper-bearish traders.

For the put buyer just to break even, they would need GME stock at $18 by July. To double their money, it needs to go to $16. And so on. We’re talking a massive decline here. Even if we assume that GameStop will drop 50% or 75% between now and then, it wouldn’t even come close to hitting $20.

As a reminder, GameStop hasn’t been below $20 in months, and since then, it has attracted a large retail fanbase. This will keep the stock from sliding more quickly, as many shares are held by so-called diamond hands.

Why Hasn’t GameStop Raised Money?

On top of that, here’s the near-term catalyst. GameStop hasn’t raised any money since its stock went to the stratosphere. This has seemed inexplicable. With GameStop pivoting its business model to digital-first, it is going to want to raise more cash.

With the stock at $275, it’d be crazy not to issue stock here. Sell a mere 6.5 million shares at $275 and you have nearly $2 billion in proceeds.

That would ensure that GameStop survives for many years. And the company has 65 million shares of stock as is, so 6.5 million shares is hardly any dilution, just 10% of the total stock. And, here’s the fun part, even post-dilution, GameStop’s share base is still small enough that that $2 billion in cash amounts to $27/share. That’d be a hard floor for the stock price.

Why hasn’t GameStop issued stock so far? In late January, it seems the company couldn’t issue stock because it had preliminary sales data it hadn’t released yet.

Then, GameStop’s CFO left. Understandably, a company wouldn’t want to issue stock when its CFO is going away. That’s asking for trouble. And now GameStop has earnings coming up on March 23. Again, it’d be questionable to issue stock right ahead of an earnings release.

GameStop Will Finally Raise Capital Now

All that to say that, remarkably, GameStop has arguably not had a 100% clean window with which to issue stock since its share price went parabolic.

The upcoming earnings report, on March 23, would be as good a time as any to do the share issuance. When you release the numbers and have a conference call, everyone has equal information. There would be no basis for legal complaints about issuing overpriced stock.

If and when GameStop issues stock on or soon after March 23, I believe the July $20 puts go to almost zero shortly thereafter as people will see the huge cash balance and say, “Well, there’s no way the stock will totally crash now.” That would generate a quick profit for the put sellers.

Why Are GME Share Puts So Expensive?

The answer is that when implied volatility goes up (such as it is right now) both call and put implied volatility go up roughly equally. Options are priced on the theory that stocks have a relatively normal distribution, i.e. their moves fall along something resembling a bell curve.

Thing is, in extreme scenarios (such as GameStop), this logic breaks down. GameStop can easily go up more than 100%. Meanwhile, in reality, a stock can’t go down more than 100%.

Yet the computer models that determine market maker option pricing raise the price of puts along with the price of calls as overall volatility increases.

However, the odds of GameStop actually failing aren’t going up. In fact, it’s the opposite. GameStop can raise capital more easily, and it’s attracting more retail shareholders who will hold the stock for an extended period.

Every day GME stock spends up here at an inflated price, the more unlikely it becomes that the stock crashes back to a sub-$20 price. Yet puts are still priced as if imminent collapse is likely.

July $20 Puts: Ridiculously Mispriced

This brings us to the July $20 put. Back in January, with the stock around $40, this option was around $4.75. That was when the option was only $20 out of the money and still had six months of duration left.

Hilariously, as GME stock spiked to $500 the first time, the option actually went up to as high as $8. This was utterly nuts. Of course, the odds of GME ending up under $20 didn’t increase as the stock price went up thousands of percent. But options are priced by computer and sometimes the computers are out of their element.

By mid-February, GME stock was back down to $40. Yet the put declined in value. Sharply!

Even as the stock dropped 90%, the $20 put option fell from that peak of $8 to just $3. As volatility plummets, the price of way out of the money puts also collapses.

With the latest run-up in GME stock from $40 to $300, the July $20 put has barely moved. It’s only slid to $2 from its previous $3 level even as the stock went up 700%.

The Bottom Line

GME stock is wildly overpriced right now. I wouldn’t want to own it at today’s prices. However, due to high implied volatility, options are also far too expensive on GME stock. Hence, the opportunity to short $20 puts and make $2 per contract in just four months. That’s a 10% return on cash in four months, or more than 30% annualized.

At worst, if GameStop does collapse between now and then, you’d get exercised on the position at an effective cost basis of $18 per GameStop share. Given that GME stock is currently at $275, owning it at $18 would hardly be the end of the world.

When markets malfunction, it creates opportunity. In this case, while GME stock is far too volatile for many traders to handle, its far out-of-the-money puts have created a wonderful set-up to generate option-selling income.

On the date of publication, Ian Bezek held a bullish position in GME stock via July $20 strike GME naked puts. He held no direct position in GME common stock.

Ian Bezek has written more than 1,000 articles for InvestorPlace.com and Seeking Alpha. He also worked as a Junior Analyst for Kerrisdale Capital, a $300 million New York City-based hedge fund. You can reach him on Twitter at @irbezek. 


Article printed from InvestorPlace Media, https://investorplace.com/2021/03/gme-stock-gamestops-huge-squeeze-sets-intriguing-bullish-options-trade/.

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