AMC Entertainment (NYSE:AMC) has now officially pulled a Gamestop (NYSE:GME). That is to say, AMC was tied to a struggling business model, faced massive obligations and appeared well down the road toward insolvency. Then, Reddit’s r/WallStreetBets community embraced AMC stock and, like Gamestop, the company’s fortunes flipped.
Look — the trading in AMC stock right now doesn’t have much of anything to do with its fundamentals. The stock hasn’t run up from $10 to $50 recently just because of small changes in movie attendance and whatnot. Rather, it’s a pure momentum play due to the clever traders that congregate over on Reddit.
As such, in analyzing AMC stock, it’s important to note how the options market is driving stock performance. With that in mind, you’ll start to see the cleverest way to profit from this situation.
AMC Stock: How Options Work in a Short Squeeze
One of the key parts of the recent short-squeeze phenomenon is that traders buy call options on the stock in question. Buying a call option has a far greater impact on an equity than just buying the stock outright. That’s because the call allows the trader to control 100 shares of stock for a nominal upfront price. With AMC stock at $50, for instance, a hundred shares costs $5,000. But a call option selling for $5 would give the trader control of the same position size for just $500 up front. This leverage allows retail traders to take gargantuan positions in stocks.
However, every transaction has two parties. Think about the person or fund selling options that have lost a fortune on these stock squeezes. By selling options, the fund is taking outsized leveraged exposure against the stock. As it rises, their losses increase exponentially. This eventually forces them to buy stock as well in order to limit their liability, causing an upward cycle in the stock price.
That’s how the so-called “gamma squeeze” goes. There’s another part to this, however. Options are generally priced on advanced mathematical models that assign something of a bell curve to future possibilities. As volatility and expectations of future movement change, the prices of options go up. It’s not just the calls, either. Market makers also increase the price of puts (bets against a stock price) in response to the rising volatility.
This is where the trade opportunity sets up. Are the odds of AMC going bankrupt now higher or lower than they were six months ago? Lower, of course. AMC has raised a ton of money with its various secondary stock offerings. In turn, that cash can be used to pay off debt or invest in needed business expenses. That liquidity gives AMC a huge runway to turn its business around.
Profiting From This Mechanic
So, how does a trader make money off this market mechanic? Simply stated, sell “crash insurance.” Market makers and bears are still willing to pay a fortune on traders that bet against AMC. Given that AMC is unlikely to go bust anytime soon with all the cash it has raised, it could make sense to take the other side of the bears’ trade.
Take the December 2021 $15 AMC put, for example. As of this writing, it is selling for around $3. Thus, in return for being willing to buy 100 shares of AMC stock at $15, you’d earn a premium of $3 per share today.
To translate that into English, the put seller is committing $1,500 of capital if the option is exercised. In return, the put seller gets $300 today. That’s a 20% return on the capital deployed in the trade, assuming the stock stays above $15. As the trade plays out in ensuing six months, this is a more than 40% annualized profit.
What could go wrong? Let’s say AMC stock actually crashes again. The trade would be breakeven at $12 per share in December. That’s because the trader would be forced to pay $15 per share for AMC stock then, but already have received a $3 credit up front for selling the option. If AMC crashed back to $9, the put buyer would double their money, whereas the put seller would lose $300. And so on.
So, theoretically, could AMC drop back to the single digits by December? Sure, anything is possible. But is it likely? Unless there is accounting fraud, a new mega-wave of the pandemic, or some sort of other completely unforeseen fiasco, AMC stock is likely to stay at or above $15 moving forward.
AMC just sold a bunch of new stock to investors at prices far north of $15. There’s no liquidity worries anymore and the company’s business is on an upswing between the specific “meme” attention its receiving as well as the broader economic reopening. It’s risky to buy AMC stock at $50. But it’s not so risky to be willing to buy the stock at $15 and earn a 40%-plus annualized return for doing so.
AMC Stock Verdict
Look — there’s no fundamental reason to think AMC stock is worth $50 per share, or really anything close to that figure. Given the oceans of dilution that have hit it over the past year, the stock’s overall upside potential has been greatly diminished. Of course, that doesn’t really matter in the short term. A squeeze can take a stock to unbelievable heights for awhile.
In the long term, though, it makes no sense that AMC is now approaching a similar value to Spotify (NYSE:SPOT), for example. Would you rather own the dominant music platform going forward or an aging movie-theater chain in the era of Netflix (NASDAQ:NFLX)? Over time, AMC would have to pivot its business model massively to come close to justifying its current valuation. And, unlike Gamestop, it’s unclear how the company could adopt a digital-first strategy.
All that said, as we’ve seen with meme stocks this year, it takes a long time for valuations to snap back to reality. Bears are betting on AMC stock crashing immediately. That’s probably not going to happen either. Thus, the best strategy for trading this name right now is selling overpriced volatility via naked puts positions.
On the date of publication, Ian Bezek held a bullish position in GME stock via sold July $20 strike GME naked puts. He held no direct position in GME common stock. He also held a bullish position in AMC stock via sold September $4 strike AMC naked puts. He held no direct position in AMC common stock. He also owned SPOT 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.
