Options traders increased bets on GameStop weeks before its price spiked, setting up for gains near 1,000%. Here’s the strategy behind it and the probability of it happening again.

Options traders increased bets on GameStop weeks before its price spiked, setting up for gains near 1,000%. Here’s the strategy behind it and the probability of it happening again.

Meme stocks made a quick comeback in the second week of May thanks to a tweet on the 13th.

At first glance, Keith Gill’s sketch of a seated gamer leaning forward doesn’t seem related to anything in the stock market. But Gill’s 2021 public analysis of GameStop (GME) became a focal point for retail investors who piled into the stock during the bull market that engulfed most of that year. Social media hype sent the stock spiking by almost 2,000% in 2021.

Roaring Kitty, as Gill is also known, had gone silent for three years until Sunday, May 13, when his tweet became the catalyst that sent GME up by 180% the following day. This is pretty impressive, but what’s more interesting about this event is what happened in the futures market before it, according to Steve Sosnick, the chief strategist at Interactive Brokers.

During the first week of May, there was a significant increase of open interest for far out-of-the-money call options, contracts that grant their holders the right but not the obligation to purchase an underlying stock at an agreed-upon price called the strike. These were at strikes of 25 and 30 that were set to expire on May 17. Those strike prices were substantially higher than the stock’s price, which was trading between $10 to $16.50 that week.

“So when someone was buying the 30 strike calls when the stock was around $17, they were basically betting that the stock would double in the next week,” Sosnick said.

As the stock began to gradually rise from $10 to $17 in the first week of May, you would expect open interest to increase for the 20 strike calls, which is what happened, he noted. But what Sosnick found interesting was that the open interest went up faster for the $30 strike calls, signaling an expectation that the price would really rally this time.

It’s an outrageous bet because the odds of GME suddenly doubling were infinitesimal, Sosnick said. It’s why options contracts were trading at cents to the dollar during the last week of April and the beginning of May. Traders who purchased contracts on May 2 for $0.56 sold them at $5.93 by May 13 for a 959% gain. So somebody made a lot of money, and it could be by employing a series of masterful strategies, possibly by utilizing social media or just recognizing the situation, Sosnick said.

The table below shows the rise in open interest on strike calls of 20, 25, and 30 set to expire by May 17 and the price of the contracts.

Table of options strike prices on GME

Interactive Brokers, Bloomberg

Tom Sosnoff, the cofounder of Thinkorswim and Tastytrade, says there’s probably a reasonable explanation behind the rise of open interest in GME. Since 2021, there have been 14 option volume spikes in GME, where traders have bought out-of-the-money options on the stock, hoping for lightning to strike again. But broadly speaking, in 95% of the cases where you have large spikes in options volume, absolutely nothing happens, he noted.

Still, traders will take their shot in the event that they get it right, either by pure coincidence or statistical chance. In reality, if you were buying out-of-the-money calls on GME over the past three years trying to play this trade, you’d be at a loss, Sosnoff said. As for the rise of open interest on the 30-strike price, he attributes it to the cheapness of those contracts relative to the other strikes rather than a function of price prediction.

Overall, buying far-out-of-the-money call options has an extremely low probability of success, but traders do it because they want to risk a little bit of money to make a lot, Sosnoff noted.

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