Examining Options Trading Strategies in Light of GME's Price Surge

According to volatility analysis from Futu Securities, the implied volatility for GME has reached 210%, with some options' volatility even exceeding 500%. In the short term, high market sentiment suggests that the stock price will experience significant fluctuations. However, given that the current market environment differs greatly from that of 2021 (with a decrease in excess savings rate and high risk-free interest rates), the current short interest in GameStop is 24%, far less than the 140% during the previous surge. It is expected that the magnitude and sustainability of this increase will not match past events, and the risk of blindly chasing high prices is considerable. Once the speculation ends and market sentiment subsides, both stock price and volatility are likely to fall significantly.

Based on these assumptions, investors could consider several trading strategies:

Selling a straddle is a strategy that bets on volatility going down, essentially based on the expectation that "future volatility will decrease." From the perspective of how volatility affects option prices, it is anticipated that a decrease in future volatility will lead to lower option prices.A sold straddle consists of selling both a call and a put with the same underlying asset, strike price, quantity, and expiration date. By establishing this strategy, an investor initially sells both a call and a put, receiving option premiums, resulting in an inflow of funds.

The characteristics of a sold straddle include:

Limited profit potential and unlimited potential loss. The maximum profit is the total premium received, whereas the potential for unlimited loss arises from the sold call option.

Time decay is advantageous to the strategy. As time decay benefits the option seller, which is a characteristic of options, it naturally favors the investor who uses a sold straddle strategy.

The strategy has two break-even points: the lower break-even point is the strike price minus the net premium received, and the higher break-even point is the strike price plus the net premium received. If the stock price fluctuates within a certain range and the losses caused by price changes do not exceed the premium received, then the strategy will be profitable.

For instance, if on May 17th the GME price is at $40 and you believe that market sentiment is already overextended, and future stock price volatility will not be as extreme. You expect that the stock price will fluctuate, but the range of fluctuation for the upcoming week will be between $20 to $50. You could then build a sold straddle strategy, assuming you sell a $50 strike call for $5 and a $20 strike put for $6, with equal quantities and expiration dates for both, collecting a total option premium of $1100. The low and high break-even points would be $9 and $61, respectively. As long as the stock price fluctuates within this range, the investor will not lose money.

However, with this strategy, it is important to note the possibility of unlimited losses from the sold call, and investors should carefully consider the timing of entry, ideally when emotional sentiment is nearing its end. Additionally, investors should determine the range of stock price fluctuation based on their own risk tolerance.

Alternatively, if at a future point in time, an investor believes that the stock price will rise modestly but upward momentum is limited and subsequent gains will not be significant, they could opt to sell out-of-the-money call options with higher strike prices to earn profits from a potential decline in stock price and volatility.

However, the risk is that if the stock price experiences an unexpectedly large increase, it could result in unlimited losses. Investors need to manage risks accordingly. For example, if on May 17th GME's stock price is $40 and the investor believes it will rise to a maximum of $50, they could sell a $50 strike call for $5, earning a premium of $500. If the stock price unexpectedly breaks through to $60, then as the seller of the option, the investor would face the following losses:

1. The loss from the option being exercised: Since the actual market price of the stock would be $60 and the strike price of the option is $50, if the buyer exercises the option, the investor would have to sell the stock at $50, whereas they could have sold it at the market price of $60, thereby incurring a loss of $10 per share. For 100 shares, this loss amounts to 100 shares x $10/share = $1,000.

2. Offsetting with the received premium: The investor had previously collected a premium of $500, which can be used to offset some of the loss.

Therefore, when the GME stock price rises to $60, the investor's actual loss would be $500. Sudden events or sharp changes in market sentiment could cause the stock price to rise abruptly, turning a strategy of selling calls into a loss rapidly. If the stock price exceeds the strike price before the expiration date of the option contract, the seller might face unlimited losses. As the stock price continues to rise, the potential loss for the seller also increases, with no theoretical upper limit. In many cases, selling uncovered (or naked) call options requires maintaining a certain margin in the brokerage account, which ties up capital and might increase due to market volatility.

The stock price reflects not only the current financial condition of a company but also the market's comprehensive expectations of its future potential, industry trends, macroeconomic environment, and market sentiment. The dramatic ups and downs of GME's stock price are largely driven by market speculation rather than changes in the company's fundamentals.

While the stock price may experience severe fluctuations in the short term due to market sentiment and trading activities, in the long run, the company's actual performance, its ability to transform its business model, and the future trends of the industry it operates in are the key factors that determine the direction of the stock price. For investors, distinguishing between short-term market noise and long-term investment value is particularly important.