Meme stocks dominated the headlines in 2021. Here is a quick explanation of how the derivatives market influences the wild price action seen in the meme stocks.

The COVID-19 pandemic led to a change in consumer behavior as well as in the way people work. Remote working has been embraced by companies that could offer it and it is now becoming part of many firms’ internal policies.

While the above were somehow logical given that the world faced a pandemic, changes appeared in the investing community, too. One major theme that dominated headlines in 2021 was the rise of meme stocks.

It all started in January this year when a group of traders, organized on Reddit, triggered one of the most vicious short-squeezes in history. The share price of GameStop (GME), a video games retailer, exploded higher on a combination of short and gamma squeezes.

Call options were used to “punish” the short interest on the stock. In the meantime, other meme stocks appeared, despite the short interest percentage of total shares no longer being that elevated. Still, the proportion cannot be ignored.

Trading Activity Driven by Call Options

Options belong to the derivatives market, and they give the trader the right but not the obligation to buy or sell a stock in a specific period. Two types of options exist – call and put.

Call options give traders the right to buy the stock in a certain period, so a call options trader makes money if the underlying (stock price) advances.

A seller of a call option may end up being forced to buy the shares, too. The increase in call options activity may force the seller to deliver the shares – shares that they do not own and need to buy in the open market. This is called a gamma squeeze and further propels the stock price.

The price of meme stocks are off their highs but still remain close to levels that do not justify their valuation. For instance, AMC Entertainment Holdings (AMC), another meme stock, is up 867% in the last six months, despite posting a loss for the year 2019 before the pandemic even started.

Only yesterday, short-sellers estimated losses from AMC positions amounted to over $450 million. Therefore, the price action in meme stocks is mostly driven by the forces in the derivatives market rather than on old-fashioned analysis of company valuation.

Without a deep understanding of derivative market forces, the retail trader is at risk, just as with hedge funds with short exposure.