If people like me still used ink rather than pixel to write, it would be safe to say that a lot of ink has been spilled discussing meme stocks like AMC Entertainment (AMC) and GameStop (GME). In just the past week and a half, I wrote about the topic here, here, and here and discussed it in the media multiple times. The action in meme stocks lends itself to multi-faceted discussions regarding short-selling, market psychology, and corporate behavior, among other topics. There is an angle that can seemingly interest anyone. Yet I haven’t fully addressed my favorite aspect of the wild trading – options. 

There is an anomaly that many have spotted in AMC options. The lines with the highest volume and open interest are the $145 calls. Bear in mind, the stock is about $55 as I write this. The stock would have to rise over 2.5x for those calls to be in the money. The easy interpretation for the high volume would be that there are some really crazy bulls out there. While that is undoubtedly true, I believe that the real motivation is more complex and actually related more to bearishness than excessive bullishness.

It is my belief that much of the activity is spurred by options traders who want to short the stock or its calls but can’t do that on an unhedged basis. A Bloomberg story on Thursday clarified my thinking on the topic when it stated that Jeffries’ (JEF) prime brokerage “will no longer offer custody on naked options in GME, AMC and MVIS [MicroVision Inc.].” It is my understanding that JEF is not alone in this practice. Buying the calls with the highest available strike is a way around rules of that type. Remember that shorting options in an activity with a defined initial profit and the potential for nearly unlimited losses. If a trader buys a long call against a short call position, no matter how ridiculously far away the long call may seem, it defines the maximum loss for the trade.

It is tempting for traders to sell calls on meme stocks. Those who want to bet against a stock like AMC might prefer to do so by selling call options. A high delta option has a similar payoff and risk structure to shorting the stock outright. At this moment, the 25 calls expiring this Friday have a delta of 1. That means that the call options are expected to move dollar for dollar – up and down – with AMC shares. A short seller of those calls would receive an initial premium of about $31 now and hope that he would be able to buy them back for something less than that before Friday. If the stock falls to $45 on expiration, the trader makes $11 (or about 35%), though if it rises to $65, the trader loses $9 (or about 30%). We can see why traders might be eager to use short calls as a proxy for shorting the hard-to-borrow shares, and we can also see why prime brokers would be reluctant to bear too much of that risk. Meme stocks can rise much faster and further than average shares, and it is the prime broker’s responsibility to cover any unpaid debts of its clients.

Volatility traders also might find it tempting to short at- or out-of-the-money calls as well. The front-week, at money options in AMC are currently sporting a robust 525% annualized implied volatility. The 70 calls, about 30% out of the money, have an implied volatility of about 565%.To make greater sense of those eye-popping numbers, it helps to use the “Rule of 16” to translate those annualized values into daily averages. Those 500+% annualized volatilities translate to average daily implied volatilities of over 30%. That is a huge number, but consider that memories of last week’s near doubling of AMC are still fresh. 

There are two ramifications to the numbers above. First of all, it is unusual to see out of the money calls have consistently higher implied volatilities than their at-money brethren. That only occurs when the market perceives greater risk (or pain) to the upside than to the downside. In a sense, that is one way to define a meme stock too. The pain trade has been on the short side, so the upside is where the speculative and hedging demand lies. 

Second, and more importantly, implied volatilities at sky-high levels mean that options decay more quickly than normal. I defy you to find a non-meme stock where at-money weekly straddles are trading at about 40% of the price of the stock. That can be a tantalizingly high level of decay for options writers, and it is understandable why many would be tempted to write options, particularly calls for those with a bearish bias on the stock. That said, we can make a strong case that the options market is pricing the volatility appropriately.   Traders who sell volatility expect the stock to move less over the remaining life of the option than the market is currently estimating. In other words, they hope that the realized volatility will be less than the historical and/or implied volatilities. The 5-day annualized historical volatility of AMC is about 600%, slightly above the current implied volatility. The market is already estimating that last week’s volatility is unlikely to be repeated. 

While I gave reasons for why a bearish trader might buy 145 calls to define his upside risk in AMC, I didn’t explain why I dismiss the argument that the action is being propelled by super-bullish traders. While it is obvious that there is great exuberance exhibited by the most bullish advocates of meme stocks (to many, “irrational exuberance”), there are many better ways even for the most enthusiastic traders to express a view on AMC. Let’s say I think that AMC can indeed triple by a week from Friday. The $145 calls that expire on June 18^th are trading for about $6.If the stock triples to $165, those calls would be worth $20, or about 333% higher. On the other hand, the $80 calls are trading for about $12.50.At $165, those calls would be worth $85, or nearly 700% higher. And by the way, if the stock were to “only” double to $110, the $80 calls would be worth $30 while the $145 calls would be worthless. Buying $145 calls makes no sense, even to an incredibly bullish trader.

I never like assuming that the other side of the trade is irrational or stupid, especially when the trade has enormous volume behind it. While I don’t doubt that some of the call buying in the $145 calls in AMC is coming from raging bulls on the stock, I am much more inclined to believe that there is a much greater likelihood that those calls are being purchased by bears who are being forced by risk considerations to buy those options for risk management purposes.

Useful links:

The Meme Giveth, The Meme Taketh Away

Embracing the Meme, AMC style

Rotation Meme Style

Making Sense of the Three Types of Volatility

Understand the “Rule of 16”