'Mortal Kombat' on the Market

We haven't gotten to actual hand-to-hand combat, yet. But some individual stocks were on Wednesday trading as violently as anything I can remember seeing. GameStop was trading at $240 in the pre-market up from a close of $148 -- which was up from $20 on Jan. 11. It was at a whopping $339 around 3:50 p.m. It all reminds me of the Volatility Index spike on the back of the destruction of old VelocityShares Daily Inverse VIX fund and the near destruction of the ProShares Short VIX Short-Term Futures fund. Their forced buying set in motion a spike in VIX futures that triggered more stops and an event that supposedly could never happen actually happened. As the Wall Street Journal had reported, Could Some VIX-Related Funds Go Poof' in a Day and A VIX-Related Fund Did Go 'Poof. In some ways, GME, is a David vs. Goliath type of story. But, instead of a sling and a small stone, the tools of the trade are short interest and out-of-the money call options. I fear that I am being too generous in viewing it this way, however, as that seems benign, if not heroic, and this activity might be anything but heroic. We can see in hindsight a few trends that combined to get us here. First, we saw squeezing in heavily shorted stocks. Earlier this year, we saw massive bounces in some heavily shorted stocks, that in some cases were teetering on the edge of bankruptcy. Remember, Hertz pulled a share offering due to Security and Exchange Commission objections, despite what seemed like a lot of demand for the stock? Second, we saw short-dated, deep out-of-the-money call option trading. Trading volumes in options have soared. Trading volumes in call options have led the way. Trading volume in short-dated options has also skyrocketed. A friend pointed out yesterday that the Friday GME $200 call options were trading! That seemed absurd enough, but they were trading at $21 at the time. At the time, GME, was trading at $140. So stock options $60 away on strike, with four days to go, cost $21? And right now, the buyer of that has doubled her money on an intrinsic basis? (I haven't see the option price, but presumably higher than intrinsic). Finally, overnight trading is responsible for large percentage of gains. While less clearly an element of some recent activity, it is still worth pointing out, again, that much of the total return of the indexes has occurred in overnight sessions. I need to update the work we had done on Nasdaq futures (here), but I mention this, because I saw a recent report saying that trend has continued and is evident in the S&P 500, as well. The trades seem to be working, because you load up on out-of-the money calls. Then you start buying the stock. The first buying forces some short covering. That raises the price of the stock. As more people buy (chasing the chart), more short covering occurs. The ultimate win is once the price rises enough that the lottery ticket option sellers, have to start buying stock to cover their gamma. That is where we tend to see relentless, almost price insensitive buying. A lack of liquidity helps (which may explain the overnight trends). Here's What I See Looming Ahead Expect out-of-the money call options to get more expensive, much more expensive. I don't see any way around this. So, expect some talk about regulatory scrutiny, which reminds me of the bulletin boards back in the late '90s heyday. Also, avoid the stocks that seem most directly involved -- if you want to know what they are, check out Reddit.com. These stocks now seem prone to massive swings, in both directions. Be cautious on stocks that may have benefited, albeit nothing like this situation, from the out of the money call option gamma squeeze trades. When something like this occurs, where technical, not fundamentals, are clearly at work, you have to think about that for every stock out there. I have no idea what the correct fundamental value for GME is. I have no clue how much the short-selling crowd impacted price. But I can say, with a high degree of certainty, that the fundamentals did not change from $20 to $240 in just over a week. There was no M&A. There was no shift in business. Nothing that I could make out as a fundamental. The point is it's heavily technicals over fundamentals. If that is true, for this stock, is it true for others? Expect lots of lists of heavily shorted stocks as people look for the next one. I'd focus on stocks that have done very well, with disproportionately high levels of weekly call option volumes, but my focus is as a contrarian on those stocks.

'Mortal Kombat' on the Market

Let's pick apart the wild action in individual stocks -- especially GameStop -- and see what to expect going forward.

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