Name That Trade – $GME: Getting Played?

by Dan November 11, 2014 1:35 pm • Commentary

Often cheap stocks are cheap for a reason. High volatility in options is usually the same way.  But while stocks that trade at a discount to their peers or the broad market are usually in the penalty box for mis-execution, it can be a lot less transparent in the options market why people are so worried about big moves in a stock.

Take Gamestop (GME) for instance.  The stock trades at 11x fiscal 2015 earnings that analysts expect to grow 23% on sales growth of 11%.  The company has a $4.8 billion market cap, and a very clean balance sheet ($193 million in cash, and $214 million in debt), pays a dividend that yields 3.1% and a year ago authorized a $500 million share buyback (here).  So what gives?  The stock is down 13.5% on the year, and down 26% from the 52 week highs made last November. Clearly, this is a long term story (physical games vs digital downloads) where we don’t yet know the ending:

GME 1yr chart from Bloomberg
GME 1yr chart from Bloomberg

The one year chart above shows the importance of the $45 level, where it broke down from this past January.  That’s a spot that has been revealed as significant technical resistance, having just failed there on Friday for the 4th time since April (we sold a long position in GME based on that $45 resistance in mid-Sept).

Without having a strong sense for console and game cycles, one would think that this stock has a pretty healthy set up heading into what should be a very important holiday selling season.  BUT the chart below of 30 day at the money implied volatility would scare the crap out of me if I were long GME:

GME 1yr chart of 30 day at the money IV from Bloomberg
GME 1yr chart of 30 day at the money IV from Bloomberg

Options prices are blowing out, up more than 80% from the August lows.  Put open interest has exploded, with total put open interest more than 2x that of calls, with 158,000 to 72,000.  Eight of the top ten lines of open interest are puts, with the greatest interest on these strikes:  21,000 Jan 35 puts, 18,500 Nov 40 puts and 18,000 Jan 37 puts.

So the stock screens cheap, but the options scream expensive.  Somebody knows something, or at least thinks they do.  GME is scheduled to report their Q3 results on November 20th.  The options market is implying a whopping 12.5% one day move, which is well in excess of the 4 qtr avg of a 4.25% and 8 qtr avg of 4.6%.

While Wall Street analysts are generally positive on the stock with 15 Buy ratings, 7 Holds and 2 Sells with an avg 12 month price target $50, some investors have taken a slightly dimmer view with 34% of the float sold short.  When we sold the stock in mid-Sept, we laid out the high bar for the crucial 4th quarter:  

Analysts have modeled in quite high expectations for the second half of 2014, with consensus EPS over the next 2 quarters expected at $2.93.  That compares to $2.48 for the second half of 2013, and that included the launch of the Playstation and Xbox consoles, as well as Grand Theft Auto V’s debut.  On top of all of that, the Xbox One has run into serious problems due to a noise problem in the past couple of weeks (see here and here).  The issue does not seem to be limited or contained, so it could impact sales figures for the holiday season.

Given the high holiday sales expectations built into analyst models, perhaps some options traders are nervous that GME offers holiday sales guidance that is weaker than current expectations.  Since the 4th quarter is expected to account for 55% of GME’s 2014 EPS, a guide lower could be a material negative for GameStop, particularly if investors are worried that it implies a lower long-term run rate for the company.

Of course, offsetting that negative view is the cheap valuation to start as well as the success GME has had in diversifying its revenue base away from just selling and renting physical games.  Its revenues have been flat while EPS has grown in each of the past 5 years.  Not exactly a great bullish endorsement, but hardly reflective of a dire scenario suggested by current valuation metrics and the high short interest.

We are fairly intrigued by the action in the vol market, that is in contrast to the price action in the stock, which has been fairly orderly. Options prices are making directional trades look very challenging, while short premium trades, fading the implied move seem to have the highest probability of success.

One trade we would consider is selling an iron condor:

For instance, with GME at $42.55 you could sell the Nov 22nd 39/35 put spread at .70 and sell the Nov 22nd 46/50 call spread at .70 for total collected premium of 1.40.

Break-Evens on Nov Expiration:

Profits:  If the stock were below 46 and above 39 you would collect the 1.40 in premium.  Between 46 & 47.40 and between 39 & 37.60 you make up to 1.40.

Losses: between 37.60 & 35 and between 47.40 and 50 lose up to 2.60, with max loss below 35 and above 50

Rationale:  While it feels like someone knows something, the highest probability of success is selling options.  In this scenario while the potential loss is more than the potential reward, it is important to note that the Nov 46 calls have a 32% probability of being in the money, while 47.40 at the upside break-even only has a 25% probability of being in the money.  On the downside, the Nov 39 puts only have a 27% probability of being in the money while the downside break-even near 37.50 only have a 20% probability of being in the money.