There has sure been a lot of buzz today and yesterday about the run up of a couple of stocks: GameStop, AMC, and others. As a prelude, I have to provide the caveat that I am trying to figure this out as write this piece.
Beyond understanding the basic concepts of how supply and demand push the prices up and down, I have never really understand how options really. I feel stupid when trying to understand. The Chicago Board of Trade defines them this way:
An option is a contract giving the buyer the right, but not the obligation, to buy or sell an underlying asset (a stock or index) at a specific price on or before a certain date (listed options are all for 100 shares of the particular underlying asset). An option is a security, just like a stock or bond, and constitutes a binding contract with strictly defined terms and properties.
This seems easy enough to understand. The next part complicates it a bit more. There are two kinds of options: puts and calls.
The call option is the easier to understand from my perspective (www.stockmarketloss.com):
When you buy a call option, you’re buying the right to purchase from the seller of that option 100 shares of a particular stock at a predetermined price, which is called the “strike price.” You have to exercise your call by a certain date or it expires. To purchase a call option, you pay the seller of the call a fee, known as a “premium.” When you hold a call option, you hope the market price of the stock associated with it will increase in the near future. Why? If the stock price increases enough to exceed the strike price, you can exercise your call and buy that stock from the call’s seller at the strike price, or in other words, at a price below the stock’s market value. Then you can either keep the shares (which you obtained at a bargain price) or sell them for a profit. But what happens if the price of the stock goes down, rather than up? You let the call option expire and your loss is limited to the cost of the premium.
The call option is easier to understand because it is part of corporate compensation for executives. Let’s say the current stock price of the company you work for is $100. You are granted options for 1,000 shares at that price but you cannot exercise the options for, say, 5 years. If the at the end of five years the price increases, to say $150, you net the $50 x 1,000 = $50,000. These options are given to executives as an incentive to drive the stock price higher.
The put option is a little harder for me to understand and it always has been. From the same website as above, here is a good explanation:
When you buy a put option, you’re buying the right to force the person who sells you the put to purchase 100 shares of a particular stock from you at the strike price. When you hold put options, you want the stock price to drop below the strike price. If it does, the seller of the put will have to buy shares from you at the strike price, which will be higher than the market price. Because you can force the seller of the option to buy your shares at a price above market value, the put option is like an insurance policy against your shares losing too much value. If the market price instead goes up rather than down, your shares will have increased in value and you can simply let the option expire because all you’ll lose is the cost of the premium you paid for the put.
More than a few folks have told me that for most individual investors, options were closer to gambling. Investment firms use them, the put parts in particular, to hedge their bets as outlined above. Hmmm, hence the term hedge funds?
So, what happened with GameStop?
The hedge funds bet on the price going down. Perhaps they did this not as a hedge but to make a killing on this company that is probably going out of business. Individual investors using social media to organize decided to take positions in the company to raise the price disrupting the investment strategy of the big boys.
Per the Wall Street Journal:
Once upon a time, short sellers were the hotshot outsiders, energetically assaulting fusty old Wall Street. Now they’re on the ramparts looking down as armies of day traders use options to send the value of heavily-shorted stocks like GameStop Corp. GME surging.
Professional investors are worried: How can financial markets function when stock movements are so obviously disconnected from fundamentals, played by both sides like a videogame? After a sharp correction midday Monday, GameStop on Tuesday rose a further 93%, bringing its total gain since Jan. 11 to more than 600%.
In another WSJ article:
In a week on Wall Street that has pitted individual investors against seasoned professionals, the trading restrictions were interpreted by many as the latest sign that financial markets are stacked against individuals. Gathering on social media platforms like Reddit, Discord, Facebook and Twitter, individual investors have piled into stocks like GameStop and AMC that were once left for dead and banded together to intensify losses among professional traders betting against the stocks.
It seems like the individual investors somehow collectively decided to buy and sell to each other driving up the price of a company on the verge of bankruptcy. The WSJ likened this to playing the market as if it were a video game. Perhaps they are. But it is still a zero sum kind of game. Some people are going to lose big time.
Today, three brokerage firms, presumably used heavily by the individual investors storming the castle, stopped trading on GameStop and other stocks in the same situation. Let’s see how this unfolds in the next few days.
It is a crazy world out there politically and also, apparently, in equity markets.
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