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How to Choose Your Own Probability of Success on MEME Stocks

I’m often puzzled by the fact that most options traders rarely take advantage of the statistical benefits options strategies offer.

For example, look at the recent wave of euphoria in the so-called meme stocks.

Whether it’s GameStop (GME), AMC Entertainment Holdings (AMC) or more recently Clover Health Investments (CLOV) the story remains the same.

Stock gets pumped up by a devoted social community of like-minded investors who prey on anything with a ballooned short interest. The stock rallies hard, in most cases, and then plummets back to earth.

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Now there is no doubt lots of eye-popping profits have been made, but there have been incredible losses as well. And unfortunately, no one wants to think about the losses.

Admittedly, I remained on the sidelines in the beginning, admiring the novelty and the wherewithal of a community intelligent enough to take advantage of a glaring market inefficiency.

But now we are almost six months into this meme-stock craze.

And professional options traders are having a field day.

It’s not because they are buying calls and puts and hoping for the best. That type of negligent approach won’t take you very far if you wish to consistently make positive returns over the long-term.

The reason so many professional traders are making money around these meme-stock events is due to volatility.

Implied volatility (IV) represents the expected level of volatility for a stock, ETF, etc. over the life of the option.

With a few exceptions, implied volatility typically rises as demand for the options increases and wanes when the demand declines.

Below, we are looking at a chart of the implied volatility for AMC. As you can see, the implied volatility was rather tame up until early 2020. The onset of the pandemic caused IV to rise, but the rise in IV wasn’t limited to AMC … heightened IVs were seen across the entire market.

It wasn’t until the beginning of 2021 that we really started to see IV push significantly higher.

The same goes for GameStop; just look at the pop in implied volatility.

Or more recently CLOV. Implied volatility has skyrocketed as of late.

But the question remains: how do professionals take advantage of the heightened levels of IV without taking on exorbitant risks?

Well, first and foremost, disciplined risk management is the key to long-term success whether you are trading or investing. It doesn’t matter the strategy of choice, timeframe, etc.; if you don’t have a strong risk-management plan in place you will eventually fail. But I digress.

Before we delve into the strategies professionals are currently using to take consistent profits from meme stocks, we first need to understand a little bit about how IV impacts the pricing of options.

When IV is high, the price of an option is high, and vice versa when the IV is low.

Quick Comparison of Different Levels of IV on the Same Stock

Let’s take a look at the implied volatility of the at-the-money strike of AMC from January 19, 2018, with 42 days left until expiration, when the stock was trading for just over 14. Implied volatility was 64.7% at the time.

As you can see the bid-ask spread was $1.40 to $1.65, so conservatively we can say that the option was selling for $1.55.

Now let’s take a look at a more recent level of IV when AMC was trading for roughly the same amount, or 14 per share. Let’s consider the July 2, 2021 options with 39 days left until expiration. IV for the 14 strike is currently 150.6%.

As you can see the price of the at-the-money option is $2.32 to $2.40. Conservatively, we can say that the option is selling for $2.36, or roughly $0.80 higher than the January 18, 2018 options.

Why is the price so much higher? The price of the stock is the same, the time left until options expiration is roughly the same, the strike price is the same, the only difference is the level of IV.

Implied Volatility

  • January 19, 2018 – 7%
  • July 2, 2021 – 6%

Basically, with all things being equal (price, time to expiration, strike price) we can truly compare the impact IV has on the price of AMC options and clearly see heightened levels of IV offers significantly higher prices, particularly on a percentage basis.

So how can we take advantage of the heightened implied volatility?

Just like with stocks, you want to sell options when IV is high and buy options when volatility is low.

Stocks inherently have a probability of success just over 50% thanks to the risk-free rate. But options offer far greater probabilities of success.

In fact, most of my trades have a probability of success between 68% to 85%, far greater than that of simply buying a stock and hoping for the best.

Going back to our AMC example, there are a few different strategies we can use, depending on your directional bias. If you are bullish on AMC over the short-term you could sell puts or even sell bull put spreads.

If I’m okay owning the stock, then selling puts would be my choice. Although in this case, I really don’t care to own AMC. Therefore, I’m going with a bull put spread.

For the uninitiated, a bull put spread, or short put vertical spread, is a bullish, risk-defined options strategy that consists of a long and short put at different strike prices within the same expiration cycle.

The stock is currently trading for 58.20.

If you are indeed bullish on AMC, you could sell the 25/22 bull put spread within the July 16, 2021 expiration cycle for a credit of $0.45 for a potential return of 17.6% over 32 days.

The probability of success on the trade is 82.52%.

Basically, as long as AMC remains above our short strike of 22 at expiration, we will collect the entire 17.6%. Our margin of error on the trade is just over $33 (current price of stock minus short strike of 22).

Now think about that for a second. AMC could move higher, remain at current price levels or push 65% lower and we would still have the potential to make a profit. Just another example why options strategies should be an essential part of every single investor’s arsenal.