These two indicators could determine whether the GameStop rally is near its end
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GameStop stock has defied gravity in the past and it could again, but there are some signs its stock may be topping out, some strategists say.
GameStop was down sharply Monday, off more than 30% at $225.
It has been the poster child of a group of stocks shorted by hedge funds but snapped up by small investors who helped drive share prices higher.
The price rises even more when hedge funds are forced to buy the stock to cover short positions.
GameStop has had a wild ride. It surged to an all time high of $483 last week but appeared to run out of steam Monday, falling well below its Friday close of $325.
The stock closed at $17.25 on Jan. 4, the first trading day of 2021.
1. Call options cost trends
When viewing a stock that’s had a long speculative run, it’s important to look at the call options on the stock when it stops moving higher, said Julian Emanuel, chief equity and derivatives strategist at BTIG.
Call options, which allow but don’t require investors to buy at a certain price, are basically bets the stock will continue to rise. Aggressive buying in those options can help speculative stocks go even higher until the options themselves become too expensive.
“The high price of the options themselves are likely to cause the stock to top and then sell-off or at least go sideways and ultimately sell off as the speculative mania moves on to different areas,” said Emanuel. “We’re seeing this today in silver.”
Silver has been the target of aggressive buying and has also caught the interest of traders in the Reddit forum WallStreetBets. iShares Silver Trust ETF jumped 7.1% Monday and call buying continued to surge at record levels in the ETF.
Retail investors have been very active in options, opening and closing positions in the same day in many speculative stocks. As for GameStop, Emanuel said the calls appear to have become too expensive to remain a source of further upside for the stock.
For instance, the at-the-money Feb. 19 call options — that is, an option with a strike price that’s identical to the company’s current share price — in GameStop at Friday’s close cost about 50% of the company’s actual share price, Emanuel said.
To give that perspective, the S&P 500 Feb. 19 at-the-money options cost just 2.5% of the S&P’s value.
“It’s difficult to maintain a level of speculative interest when it becomes too expensive to buy call options,” said Emanuel.
2. Reduced demand
Two other factors depressing the stock are the reduction in short interest as investors were forced to cover shorts, and that brokers have restricted buying in GameStop, Emanuel added. That takes away an important source of demand, and speculative investors become less interested, he said.
“It seems the Reddit army is moving into a different area,” said Chris Murphy, co-head of derivatives strategy at Susquehanna International Group. “The stock is going down and the volatility goes down.”
“Usually when a stock goes down, volatility goes up,” he said. “In this instance, as people leave and move into other areas, you’re going to see the stock price and volatility go down.”
The 30-day implied volatility in GameStop options on Friday was 430% but it declined to 375% and continues to fall, Murphy said. Implied volatility measures the expected swing in a stock’s price.
That means investors are now expecting a move as big as 23% in the stock in one day in either direction, down from 27% on Friday.
Of course, GameStop has also been affected by trading restrictions.
Robinhood and other online brokers last week limited buying in GameStop, but allowed investors to sell. Brokers raised margin requirements on GameStop and some other stocks.
It’s very hard to tell whether GameStop was near a top because of restrictions on the stock, said Steve Massocca, managing director with Wedbush Securities.
“When you tell people they can’t buy but can only sell, of course it usually goes in one direction,” he said.
Robinhood on Monday continued to prohibit clients who own more than 20 shares of GameStop from buying any new shares.