In my first post about trading parabolic meme stocks, I describe a covered call strategy that anticipates a stock’s continued momentum burst, which squeezes up for a few days, before collapsing back down: Trading in a Meme Stock World.
Today’s post expands on the idea, and shows a high probability trade that profits, if the parabolic crash up has already happened and options have become very expensive.
After recent meme stock squeezes, frequent complaints by traders could be heard all over social media: put options did not work as advertised — despite a 30% or 40% drop in stocks like GME or NIO even OTM put options bought with excellent timing lost money.
How is that possible? The answer is simply that those options got too expensive to work as planned. Specifically, one component of options pricing shot up to unsustainable levels: Implied Volatility (IVol).
Looked at in reverse, this leads to a compelling case for selling cash secured puts, when option prices reach irrational levels.
The Gamma Squeeze
Market makers, who take the other side of the option buyer’s trade, will quickly jack up option prices across the board to be able to cope with the risk inherent in a highly volatile gamma squeeze: When increasing volumes of out-of-the-money (OTM) call options are bought, dealers need to buy the underlying stock as a hedge, and, as the stock goes up, they need to keep on buying in order to control their risk, which results in an upward spiral — the Gamma Squeeze.
This relative price bump in options is visible in rising levels of IVol, which can shoot higher into ranges of up to several hundred percent — albeit only for a short time, until volatility inevitably falls back down into a more sustainable range.
Sooner rather than later, options will become so expensive that rational traders are increasingly unwilling to buy them, and more and more option sellers step in to take advantage of the opportunity.
And, ever since the epic GME gamma squeeze in the beginning of the year, which put a lot of strain on the system, options dealers have become a lot faster in initiating a price raise — the range of parabolic moves today is likely to be more subdued, as long as this reaction stays in place.
High prices become the cure for high prices, and lead to an unwind of the crash-up dynamic.
What do Implied Volatility percentages signify?
Note: For this strategy, I like to use options that have 4-8 weeks to expiration, rather than the popular weeklies, because this increases the chance that a profitable price target will be reached at some point within this time frame. (I base all numbers and calculations here on the July 16th 2021 OpEx.)
Implied Volatility describes the expected future price range of a stock as an annualized percentage. IVol divided by 16 (√252 days) will give us the expected average daily percentage move up to the point when the option expires. Looking at the options chains of some popular ETFs and stocks in a free online tool we can see that the S&P 500 is expected to move less than 1% per day, whereas AMC’s option prices imply an expected move by a whopping average of 20% every day all the way to July 16.
|Stock||Implied Volatility on June 7 (ATM July16 Put)||expected average daily move|
This extremely high expected future volatility for AMC is a direct result of last week’s gamma squeeze, which has the characteristics of a crash up: IVol rises while the stock jumps in value.
Conversely, expected volatility will come back down, if the stock price should fall (normally IVol rises with falling prices). This will lead to a loss in options value, which will likely exceed the expected gain an OTM put option shows, when it moves closer to its strike.
This highly unique circumstance represents a very large range of possible positive outcomes for a short put position, because, should the melt-up continue, the option moves away from its strike and its price will also fall — especially as time passes and IVol falls when an eventual period of calm arrives.
Selling a put on AMC
Does it really make sense to sell cash secured puts on AMC (or other parabolic movers), even if we think the stock is very likely to fall sooner or later?
Let’s see what happens to a short put position in a simple scenario: Last week’s parabolic rise in AMC stock led to overly expensive options, which may end the gamma squeeze, as fewer buyers are willing to pay such high prices. I would expect AMC to show a typical retracement of approximately 2/3rd of its rise quite soon.
The key idea for this trade is that this scenario would lead to an IVol crush back down towards the previous volatility range for the stock between 100% and 200%, especially if it settles into a calm range at lower prices for a couple of days.
I would plan to sell the July16 $25 Put option, as the strike is at the lower end of my target range and the premium is still juicy. The current premium is $4.80 with AMC at $48 using the Black/Scholes formula — a nice 19% premium, if the put is fully cash secured for a potential assignment at $25:
I think, that this scenario may play out quite quickly, and we might settle down in a lower price range around $30 by next week with IVol down considerably, which would enable me to close the put at less than half the price I got paid initially:
In practice, I would probably wait for an intraday dip to AMC $30-$40 to get paid an even higher premium for my option, or to be able to select a lower, safer strike for the same reward.
What could possibly go wrong?
Another useful tool shows the range of possible outcomes over time:
Possible alternative scenarios:
- The dreaded scenario of a continued melt-up with indefinite risk, when shorting a stock or writing naked calls (very risky!), poses no problem for a short put: it expires worthless on July 16 and we can collect the entire premium at any AMC price above $25.
- The stock falls quickly, but exceeds the target. At AMC $20.20 the trade would break even, and we would get assigned the stock for the price it trades at ($25 minus the premium of $4.80). Any lower price than that would lead to a book loss (worst case: a $2020 maximum loss, if AMC goes bankrupt within 6 weeks — not a likely scenario with all the cash they just raised from stock sales).
Now our option after assignment remains to close the trade at a loss, or to consider this a price we would like to own the stock for the longer term, anyway.
- As the path to lower prices is also not likely to just be a straight line, any pop above $25 could be used to close the put option at a profit, as we get closer to expiration.
So, all in all, AMC could rise indefinitely, fall by up to 57%, or anything in-between by July 16 and the trade would make a profit — furthermore AMC would only need to trade above $25 at some point after the end of next week, and falling implied volatility in combination with time decay would ensure a quick profit.
In addition large open interest in short put options incentivizes dealers to buy stock as prices fall, putting a natural floor for the stock at areas of high options’ open interest.
And, last but not least, the maximum risk is capped — realistically AMC should at the very least remain a $10 – $20 stock for the duration of the trade.
This is why I consider this a very compelling case for selling cash secured puts.
Please make sure to check the numbers, make your own calculations and risk assessment before you trade — this post is not investment advice and it’s your money at risk!
Good luck with your trading, and thank you for reading!
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