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Wednesday, February 3rd 2021

GameStop Puts In Demand And The Importance Of Put Spreads. Reuters Quotes Matt Amberson.

Puts have been the star of options trading in GameStop lately but straight puts with high implied volatility can be problematic.


GameStop puts have been in high demand due to the difficulty of shorting a stock with over 100% of the stock shorted. However, buying straight puts with high implied volatility can severely cut into profits even if the stock moves in the desired direction. A put spread can help mitigate this issue, as it reduces the impact of vega, an options greek that reflects the sensitivity of options price to a move in implied volatility.

GameStop puts traded 250% more than calls yesterday on a bad day for the stock price, closing at $90 down 60%. The open interest on puts outnumber calls by 600%. 

Why? My thoughts, as I was quoted by Reuters article here, “People are putting on puts in order to profit from the eventual GameStop short squeeze to be over." Since those people find it very difficult if not impossible to short a stock that has over 100% of the stock shorted, the use of puts are a natural answer.

However, the implied volatility has been astronomically high as I blogged about here:

Put buyers have found out the hard way that buying straight puts at these implied volatility levels can severely cut into profits even if the stock goes your way.

For example as @mark_down pointed out on Twitter, with the stock at $320 Friday, let's say you bought the $25 strike puts for $5.50 with a March expiry. Today, with the stock at $100 those same puts are trading $4.50. You would be down 20% on your puts with the stock moving your way down 70%.

The reason for this anomaly is that implied volatility moved against you. A put spread would have helped but still there is vega in a long put spread, and the vega is why you lost so much. Vega is an options greek that reflects the sensitivity of the options price to a move in implied volatility.

Alternatively, you could have bought a 40/25 put spread for about the same price as a 25 put on Friday. Today that put spread is worth $7.00.  At least you'd be 35% profitable.

How do you know if implied volatility is "astronomically high"?

One way is to look at the actual volatility or as it is also known the historical volatility (HV). ORATS uses a modification of HV know as the Parkinson method that uses the high and low prices of the stock to formulate a reading. This method has the advantage over traditional close to close methods of measuring volatility that a one-day vol can be obtained. Below is a graph of the one-day ORATS HV.


Looking at that graph, you can see why the IV got up to 1000%. However, volatility is often short lived and mean reverting. Don't expect GME to be this crazy too long.

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