Trading in a Meme Stock World

The current market environment is ripe with high-flying stocks and excessive options speculation — often devoid of any fundamental justification or traders’ sensitivity to exorbitant option prices. Gamma- and short-squeezes abound, and the market is full of great opportunities, if you are looking for momentum bursts leading to epic parabolic rises and collapses. This is so prevalent that the phenomenon even got its own name: Meme Stocks.

GameStop is the poster child of the meme stock world

This leads me to write this article about ideas and methods for catching part of a short-term momentum burst (lasting 3 to 8 days), then fading the parabolic move using covered call options that capitalize on elevated option premium.

Reliability of Momentum Bursts

I have traded the fade of parabolic moves for several years with good results, using methods I describe in an older article Trading Parabolic Moves (…after the fact).

Evidence for Momentum Reversals
I still find the most reliable evidence for predictability studying the collapse of a parabolic move. However, due to the extreme dispersion in the size of those moves, they are difficult to trade in a risk-controlled way.

“The evidence suggests that the “winners” and “losers” one week experience sizable return reversals the next week.” Lehmann (1990).
Similar results for a monthly reversal effect were initially found by Jegadeesh (1990) and in many newer studies for time periods between 1 to 4 weeks, for example, Groot, Huij, Zhou (2010).

Outright short positions carry high risk and often high borrow cost, while naked short calls can easily lead to large drawdowns and margin calls. Put options demand such high premium that their profit potential is small, even in a best case scenario. Bear call spreads were my preferred method, as they work well to control risk, but the huge advantage of expensive options premium for option selling is largely negated here (a bear call spread sells an ATM call and buys an OTM call at the same expiration, thereby capping risk, but earning and paying elevated premium at the same time).

Evidence for Momentum Bursts
Finding independent, quantitative data on just how well trading upside momentum bursts actually works is more difficult, but there is a lot of anecdotal evidence from successful traders that use discretionary filters to trade momentum breakouts extremely profitably. It is very easy to be fooled by hindsight bias, however, because successful examples are so blatantly obvious, and testing for discretionary technical breakouts in a way that includes all failures is difficult.

I decided to fall back on a basic 52-week breakout (daily close) to run tests, and, as with other breakout and trend methodologies, these show a positive momentum effect: continued momentum for several days is followed by a short-term reversal over the 1 to 4 week time horizon, and then the well-known 1 to 12 month momentum effect kicks in.

Trade Scenarios

Apart from the ideal momentum burst and collapse (e.g. in the GME chart above), we have to take into account outright failures (false breakouts), as well as momentum that continues above and beyond expectations or consolidates in a sideways move instead of retracing a large part of the parabolic rise.

RKT failed quickly, but had already showed two range expansion days prior to its breakout

Realistically, the ideal trade will occur only in a minority of cases, so I aim to construct a strategy that is profitable in all of these scenarios, except for an outright breakout failure.

Gamma Squeeze

The real juice for parabolic moves often comes from an options gamma squeeze and we can glean valuable information and use predictable mechanics through the options market.

In a gamma squeeze, traders buy call options from market makers, who immediately delta hedge that call sale by buying the stock, which creates initial demand. Market makers now must buy more of the stock as it rises, to hedge their risk, as the call options move in-the-money. This cycle triggers a constantly rising demand for the stock, and its price spikes.

Rising open interest in the OTM call option chain can be an indication of an imminent gamma feedback loop, with low float and high short interest strengthening the setup.

Very notable, especially after the epic February 2021 GameStock gamma squeeze, is a fast reaction by options dealers: they quickly raise options premium / implied volatility to avoid extreme moves spiraling out of control. We can spot this attempt to smother a squeeze by extremely high premium (larger than 25% for 1 month ATM options) and high levels of implied volatility, indicating a limit to the momentum move (as fewer traders buy at crazy prices and call selling becomes attractive).

Areas of the highest open interest form a natural barrier for a stock’s rise, as dealers’ hedging activity peters out, unless new calls are bought at higher strikes. (If there are no higher strikes available, this points to a limit for a rally, until new strikes are opened by market makers the next day.)

These ideas can be used to fine tune trade selection, and high option prices are the basis for including covered short calls in a strategy.

Parabolic Momentum Trading Strategy

Mulling over the puzzle pieces collected above, as well as past trading experience that shows that my short entries were usually early, I came up with a refined strategy idea. It aims to take advantage of an initial momentum burst to new highs and add a covered short call to earn the fat premium on the way down, while capping risk.

To do that, I spread my entry into a stock plus covered call position over several days:

On a 52-week high breakout (less than 3 expansion up-days at this point, filtered for high-momentum stocks), I buy the stock at the next day’s open (in 100 lots);
Alternatively, one could buy an OTM call option to take advantage of convexity and an anticipated spike in premium, but with a riskier exit in case of failure;
Monitor the option chain for an indication of a potential gamma squeeze and its likely targets to filter for favorable reward to risk opportunities;
Place a stop loss at a daily close below the breakout level (previous 52-week high), which defines the risk and position size for the trade;
If the stock continues to rise, sell covered ATM calls (1 call for each 100 shares) at day 3 to 5 of the momentum burst at gamma squeeze targets — premium should be elevated in a parabolic move;
Sell the stock when the short calls are profitable enough to place a (mental) break-even stop loss;
Close the short call when the stock retraces back to the 20 dma.

Current Example: Upstart UPST

Last Thursday, March 18, UPST appeared on my breakout screen with a 100% jump to a 52-week high, with options already commanding a high premium (20% for 1-month ATM calls).
The best bet was to play the stock outright and buy at the next day’s open in 100 lots, but this was relatively expensive at $110 x 100 = $11,000 for one lot.
Place a stop loss at a close below the old high ($102) at a risk of about $1000 – $1500. Prudent position sizing would risk 0,5% to 1% of trading capital.
Alternatively, buy OTM 185 April16 Call Options at $6 (these rose to $20 by Monday’s close with higher leverage than the stock, but also with the risk of losing 50% to 100% of the premium in case of failure. This would be especially favorable when an entry occurs before options dealers raise the option premium, but in this case has no great advantage over buying the stock.)
Options chains showed high open interest at the 120, 130 & 135 strikes, as well as increased volume at 150, but no increased spike of implied volatility yet.
On Monday, March 22 (the 3rd day of the momentum burst), UPST reached $160+ towards the close, which was a profitable entry point for a short position to fade the move, as the stock is up $5000 (or 45%) per 100 shares. Such strong bursts, even though they seem common in the current environment, are quite rare.
Play the fade of the parabolic move by selling a covered ATM call option on the stock (1 option equals 100 shares) to earn the fat premium: ATM 160 April16 Call Option at $28 earning $2800 (or 17,5%) in premium.
For several 100 lots of shares one could sell options staggered across day 3,4 & 5, while watching changes in the options chain for potential targets.

What happens now?
(1) Either the stock never sells off below $160 and we can cash in $7800 (70%) in profit at expiration in April (the short call locks in the stock’s $5000 profit at $160 and we earn the $2800 in premium through time decay).
(2) Or the stock consolidates or falls below $160, and we sell the stock as soon as the short call shows enough profit to be placed at a mental break-even stop loss. An exit at $150 may be a good balance to lock in $4000 in profits for the stock.

As parabolic rises collapse quickly most of the time, we can often close the options position within a few days, aided by the rapidly falling implied volatility in the market makers’ pricing. Note that with an option exit target of $8 (around the stock’s 20 dma), we would keep $2000 of premium and make $6000 (55%) altogether.
This trade takes a fraction of the time compared to the wait for expiration, and it frees up capital quickly.

In case the option gets stopped out, we would still end up with a profit of $4000 (36%), while risking $1000 – $1500.

*While editing the final draft of this post on Tuesday, March 23, the exit target for the stock ($150) was reached shortly after the open, and the exit target for the option ($8) near the daily close, as UPST fell by 28% ($118).

The collapse of inflated option premium can happen surprisingly quickly, and the exit price was reached while the stock was still trading far above the anticipated exit point, its 20 dma.

This is an ideally profitable trade and only in the current, extremely speculative meme stock world can we realistically expect such an outcome.

I am in the process of refining and beta testing this strategy (alongside the “Vanna Nights” strategy) over the next weeks and will soon include successful versions in my weekly premium report.

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Good luck with your trading, and thank you for reading!

David