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In December, I wrote an article suggesting investors should make covered calls on GameStop (NYSE: GME): Buy GME Stock and Take Advantage of the Bold Call Option Rewards It’s kind of conservative Tech Investors Making Money On A Stock That Is Too Hot To Buy But Too Strong To Ignore

Investors following this strategy would have seen a 25% gain in three weeks – not bad for an options strategy with a limited upward trend, but with stocks down $ 1 since last year000%, people ask themselves, “How did we get here in the first place?” The answer is a complicated mix of finance, dynamics, and a virtual chicken game here’s how to get to our location and where GME stock could go next

In a year when both Microsoft’s Xbox (NASDAQ: MSFT) and Sony PlayStation (NYSE: SNE) have finally released only digital versions of their consoles, you might think GameStop stock investors are panicking The company had resisted calls for modernization for years.Instead, the stationary relic stayed alive thanks to its cash cow: the lucrative second-hand game market.And now that many next-generation game consoles no longer require physical games, GME stock is likely to fall

GameStop shares did the exact opposite of what you might expect, however, in evidence that no amount of wisdom can predict the madness of crowds (or internet users), stocks rose 150% when I suggested profits to take off the table Since then, the stock has tripled

Long-term investors with a sense of humor might remember the Financial Times suggesting that the then-dying RadioShack could start selling fruit baskets or turning stores into Zumba studios in order to survive (A small town in Weaverville, CA, seems to have done just that) That’s because in the brick and mortar retail world, those who don’t conform, like Blockbusters and Circuit City – end up in bankruptcy court explaining legal fees to disgruntled investors

GameStop seemed destined for the same junkyard for years.Although management successfully campaigned for Microsoft to keep drives in the Xbox One in 2013, the company couldn’t use that lifeline to migrate to online and mobile games

The release of the PlayStation 5 and Xbox Series X blockbuster messed up Wall Street’s tea leaves with both consoles sold out in minutes, analysts scrambled to revise GameStop’s estimates at short notice, Wall Street now expects sales to surge 45 % this quarter, reversing after years of decline, and bullish retail investors went wild, sending the stock down from $ 4 to $ 14

Retail investors weren’t quite finished, however. A strange phenomenon emerged in December: open interest in GME calls had reached unprecedented levels as online investors spurred one another in. In other words, investors weren’t just betting on that GME stocks would go up, but also that profits would come sooner rather than later.And whenever this happens, investors can inadvertently enter a feedback loop.This is because buying call options en masse also forces market makers to use the underlying Buying security – in this case, GME shares. It is a process known as delta hedging in which market makers like the New York Stock Exchange attempt to maintain a neutral position

Meanwhile, rising stock prices are forcing short sellers out of their positions and causing them to become buyers in what is known as a “short squeeze”. “This is forcing stocks even further into (reportedly) increasing numbers of online users shopping and so on Ultimately, the company’s shares become a caricature of the intended price

And how long can the mania last? A) If someone is unfortunate enough to fall short, the feedback loop will usually continue just long enough to force them out of position at a loss. B) If they are long, the loop will last just long enough for them to convince themselves have that the stock is a long-term winner; and c) if they don’t own the stock and decide to buy it, this is usually exactly when the bottom falls out

It’s not the first time a brick and mortar store has sparked such investor frenzy. Nearly a decade ago, GNC found itself in the eye of the protein supplement storm, what was once the job of bodybuilders suddenly saw its 15-minute glory via the U.S. The GNC inventory rose from $ 15 in 2012 to nearly $ 60 by the end of 2013 and was armed with the protein “miracle cure” for everything from weight loss to building muscle

At the time, options trading was much more limited, however Robinhood had only just begun, and most retail investors did not have the tools to put market makers and short sellers into an upward feedback loop even as bearish short interest in GNC stocks increased , Short squeezes rarely amounted to more than 20% price jumps

GameStop, on the other hand, makes GNC look like a breeze. Today, GameStop has a short interest ratio of 109%, which means more stocks are sold than sold

And GME’s open interest in nearly 850000 options is seven times higher than that of Best Buy (NYSE: BBY) 115000, although GME is less than one-tenth the size of the latter company’s $ 20 price target for GameStop, while Citron Research’s $ 20 target may be correct, but nothing can stop retail investors from getting GME to $ 60 and up in the short term bring there just aren’t enough stocks to sell short

It’s impossible to know how far GME can go from here. The company now trades for 373 times its Shiller price-to-earnings ratio (P / E), a measure of long-term value. Nowadays, stocks are less like it the steady state 36 times that of Best Buy than rather the high-growth 355 times that of Amazon (NASDAQ: AMZN)

If your company’s stock value isn’t tied to real life, then what can stop it from rising 600x or more? The Dutch tulip bulb mania from the 17th century The 20th century is a sobering reminder of mankind’s ability to ignore reality. In its prime, the most expensive lightbulbs could cost more than a house

Those who insist on profiting from GME should consider selling options and hedge with a position in the underlying security – much like professional market makers do, with an implied volatility close to 180%, GME options become sold for big margins 2022 calls cost nearly $ 16

But don’t go bare short or long GameStop and expect easy wins.If we stumble through 2021 together, it would be wise to remember: GME shares could continue a run up to $ 60 and beyond if the Short Squeeze (and the Internet cheerleaders) continue their cheerful mischief

But if GameStop management doesn’t use the momentum to overhaul their business, it would all be in vain Because as hundreds of defunct brick and mortar businesses can attest, a bankruptcy court will ultimately do it for you if you don’t stop yourself to pursue an outdated business model

At the time of this writing, Tom Yeung held (neither directly nor indirectly) positions in the securities mentioned in this article

Tom Yeung, CFA, is a registered investment advisor committed to making the world of investing easier

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