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Trading Meme Stock Volatility
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Ever wondered what's it like to be a degenerate options trader?
Do you know how it feels to make those life-changing gains?
Want to learn how to take excessive risks with your money and lose it all on one trade?
Let me take you on this journey.
Let’s go back to the summer of 2021.
June has just begun, and the markets were going through another meme-stock frenzy. The stock of AMC Entertainment almost doubled on 2 June, closing at $62.55. Reddit was full of various accounts boasting their AMC gains:
Looks good, doesn’t it? Maybe it’s worth getting into AMC ourselves?
But when? Should we get in now? What if it doubles again tomorrow? But what if it doesn't? If only there was a pull-back, we could probably get in...
On 4 June, AMC drops to $47.91 per share.
OMG, this is it! This is the moment! This is the DIP! And we all know what to do with dips, don't we? ;) Let's not waste this opportunity.
We briefly consult our trusted financial advisor, and FOMO tells us to go all in! Thanks, FOMO!
So what do we do? Buy the stock?
Yes, but with stock, you can't achieve those +5000% gains of an average WallStreetBets anon account. We need something more powerful. Let's go with options!
Let's see. Next month's expiry should give us enough time to see AMC reaching the moon, so let's have a look at July 2021 calls.
At-the-money (ATM) options are a bit too expensive, but let's not go too crazy out-of-the-money (OTM) either. After all, we're not complete degenerates... 50 strike looks good. Nice and round number with high open interest and good liquidity.
The price is $2,141 for one contract. If AMC reaches, say $150 in the next month, the option will pay:
($150 - $50) * 100 = $10,000 minus the premium.
Ok, not bad. With around $25k sitting in the account, we can afford to buy 10 of these bad boys for a total price tag of $21,410. Potential gains could be $100,000 or more. It sounds like a perfect YOLO trade!
And it's done! Let's go, baby! #AMCStrong #AMCSqueeze #AMC500k #OccupyWallstreetAMC
Now, the AMC stock didn't skyrocket over the next few days but did not disappoint either - it traded above $60 and closed at $58.11 on 28 June.
This is fantastic! Our long calls are in-the-money and probably pumped up our account a bit.
Oh, we really should've taken more leverage with our position!
Speaking of which - how much *gainz* did we make? Let's check.
WHAT?! No, how could this be?! The options are in the red!! They lost -38% of the initial value?
How is this even possible when the stock gained +21%? Did we fat-finger buy puts?
*checks the positions*
No, they're calls. And they're trading at $1,320 each.
So the stock went up, and we lost $8k on the calls?! The market must be rigged against us!
Ok, let's cut the losses short and figure out what went wrong.
(In hindsight, it's great that we didn't hold till expiry. Had we not closed these calls on 28th June, they would've expired worthless on 16 July, as AMC closed at $34.96)
Playing 3D Chess
It's easy to get swayed by FOMO, the noise of the crowds and the sweetness of potential profits when the stock shoots for the moon. Especially when these profits can be multiplied many times over due to the leverage offered by options.
However, the aerodynamic properties of your favourite meme-stock is not the only thing to consider when YOLO'ing your hard-earned savings on out-of-the-money calls.
Options work in multiple dimensions and are exposed to other factors, in addition to the underlying price.
One of such factors is implied volatility, which is directly correlated to the options price - the higher the implied volatility, the more expensive an option (all else equal).
Very often, when a meme-stock is headed for the moon, its implied volatility is going the same way. This represents the additional uncertainly around the future stock price, as no one knows precisely how far will the WallStreetBets crowd take it.
This also represents an additional headwind – it’s more costly to make bets using calls.
For an expensive call option to be profitable, the stock has to do a lot of the work - not only it needs to rise, but it needs to do so with a LOT of volatility to justify the expensive price tag.
If it doesn't rise with enough vigour, implied volatility will fall and the option will lose in value.
Unfortunately, this isn’t good news for option holders. In case the gains from the stock going up (delta) are smaller than the losses from implied volatility falling (vega), then the net position will be a loser.
This is exactly what happened in the AMC example above. A few days before our trade, AMC closed at $62.55, and its implied volatility spiked to just over 450%. This is very high, even for the king of memes.
When we entered the position on 4 June, the calls we bought traded with an implied vol of 360%. Unfortunately for us, over the next month, volatility came down further, and by 28 June, the calls were priced with an implied vol of 180%.
Despite the stock rising +21% over the same period, this was not enough to offset losses from lower implied volatility. Hence, net-net, we lost money on the trade, despite the correct call on the stock price direction.
Daily Theta Burn
In addition to volatility, there is another cost when holding options, known as theta.
Since options are a decaying asset, they lose value as time goes by - with less time, there's less opportunity for the stock price to cross over the option's strike.
When buying out-of-the-money options, the entire option's premium represents the so-called "time-value", which will disappear by expiration date. Unless changes in underlying price or implied volatility offset this, the option value will decay with each passing day.
This decay is not linear. However, there's a simple trick that we can use to approximate the cost of holding an OTM options position.
Time Decay = Option's Premium / Days Till Expiration
This number will tell us how much, on average, it costs us to keep a long option position open.
In the AMC example above, the total cost to purchase 10 OTM call options was $21,410. The number of days till expiration (DTE) was 42. This means that if nothing changes, each day we would expect to lose:
Time Decay = $21,410 / 42 = $510.
AMC might be going to the moon. But it has to go there fast enough for our options to overcome the average daily theta burn of $510.
And any unfavourable moves in stock or implied volatility will further add to theta losses.
When opening a long call trade, it helps to get a quick sense of how quickly the option will decay. Is there room for implied volatility to rise to compensate for that? Or will the share price do most of the heavy lifting?
If the implied volatility is high - and with meme stocks it usually is - the theta burn will be ruthless, and even a significant rise in the stock price might not be enough to offset the time decay.
And this is certainly something to keep in mind during the next episode of an options-related FOMO...
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