Video game retailer GameStop (NYSE: GME) traded under $3 not even a year ago. And now, after cooling off a bit, it’s trading around $300.
Almost everyone is either talking about this wild price swing or is actively trading it. If you still have questions, we’ll answer some of those today. Either way, it’s showing people what to do, and what not to do when it comes to investing.
It’s not even over yet. And I’m glad we are seeing it play out on such a big stage.
There’s a lot you can learn from it … and not just with stocks.
This situation is giving us a front-row seat to the benefits of making options your No. 1 trading vehicle.
Let me explain…
What Went Wrong
Let’s start with what went wrong.
As my colleague Charles Mizrahi showed you yesterday, starting late last year, shares in GameStop began to rally. Then, this year, they blew the lid off that rally as more investors piled in with more buying pressure.
This whole saga around GameStop boils down to a simple short squeeze.
A short squeeze happens when a large number of a company’s shares are sold short (betting that the stock will fall lower). Hedge funds on Wall Street did this by essentially borrowing the stock from their brokers to sell back later, pocketing the difference if the price falls.
But so much of GME was sold short that those shares that investors borrowed were being borrowed again by other investors to bet on a fall.
The numbers were unsustainable. The number of shares that were sold short were more than the number of shares on the market.
Things would have had to go perfectly for those short sellers to make money. And, as we now know, things didn’t go perfectly. All it took was for some other hedge funds and individual investors to decide to take the other side of that trade.
There was a surge in buying, and those who shorted the stock were forced to buy their shares back, taking massive losses and adding fuel to the buying frenzy.
This is an extreme version of a short squeeze.
Now, all of this will finally be over when prices come falling back to Earth. And it’s when, not if.
GameStop’s fundamentals are weak, at best, and its business model is failing.
The company has made its revenue over the years from its brick-and-mortar stores — selling games and accessories — but with the online gaming industry booming, GameStop has failed to keep up.
It’s going to have to change its identity to bounce back from where it was, and we haven’t seen that happen yet.
The bottom line is that the funds trying to short the stock had taken too much leverage and practiced poor money management.
Again, as Charles said yesterday: Shorting a stock has a limited profit, and an unlimited potential for losses.
When you short a stock, the lowest it can go to is zero. So, if you short a stock at $10, the most you can make is $10 when you buy it back.
However, if you short a stock at $10 and it goes to $100, you lose $90 (assuming you have ample funds to hold the position). And there’s no limit on how high the stock can go. That means you’re looking at limited gains, but unlimited losses. It’s a terrible risk-reward ratio.
You never want to short a stock.
If you ever feel like a stock is headed lower, there’s a much safer way to play it…
This brings me to one of the lessons we learned from all this — and why options are still my No. 1 trading vehicle.
The Safer Way to Play the Fall
Buying put options is the best way to profit from any expected decline in a stock. Not shorting it.
GameStop is too volatile to trade options on right now. But, if you come across another stock that you have a high conviction it will go lower, buying a put option is the best approach.
When you buy a put option, the amount you spend on the option is the most you can lose.
For example, if you spent $100 on one put option contract, the most you could lose is $100 (a 100% loss). Meanwhile, your gains on a put option can soar more than 100% — a much better upside potential than a short.
And you can look at the costs of the option compared to the expected move of the stock, and you’ll understand your risk for the potential reward you are trying to get — a defined risk and upside potential on your profits.
That’s the kind of risk-reward scenario you want, regardless of whether it’s a stock going up or down. And options provide you with exactly that.
Again, the volatility on GameStop’s stock makes buying options for any of these moves not worth it right now.
But there’s another option strategy you can use … and still make some money from this wild market.
This Friday in my Weekly Options Corner (my weekly newsletter, where I tell you everything you need to know about options), I’m going to highlight how readers can use options in this trade … by showing you the simple way my readers are pocketing a 16% gain in GME over the next two and a half months.
The only way we can lose is if the stock plunges more than 97% in that time frame.
This opportunity is a no-brainer.
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Chad Shoop, CMT
Editor, Quick Hit Profits