Trades

GameStop’s Bad Week Gives Us a Volatility Trade

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Earlier this week, the video game industry made a giant leap toward a new future that the movie and TV industries have been living in these past few years.

When you think of Blockbuster, the company, you think of the old derelict abandoned buildings that once were cornerstones of the ’80s and 90’s entertainment.

Driving out to blockbuster with the family, picking up a few movies to watch as a family on a Friday night was a treat to many. It was also just the way a lot of people consumed their entertainment.

But that changed with the rise of Netflix, Hulu and now Amazon, HBO Go, and others. More recently, we’ve seen the toll this instant gratification and improved convenience took on companies like Toys ‘R Us and Radio Shack.

So, why shouldn’t the video game industry deal with the same kind of shake-up?

Sure, for years now, PC gamers have been able to get their games on Steam and other less popular but still profitable download platforms. Even console players – those that game on Microsoft’s Xbox and Sony’s PlayStation – have had the option to download their games directly. But now, for some, that’s becoming the only way to game.

Well, almost.

You see, on April 1 – just a few days ago – Sony ended retailers’ ability to sell full game download codes. Meaning, it is cutting out companies like GameStop (GME)… the giant in video game retail.

Customers can still buy bonus material, hardware and physical copies of games. But Sony is severing the link between digital and physical “in order to align key businesses globally,” according to a spokesperson.

Now, this truly doesn’t seem to change much. But it does highlight the rapid change going on in the industry. It has been going on for some time now. But like cable and satellite TV, and Blockbuster before them, the video game industry is reaching a tipping point.

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You can see this shift in the graph above from Statista. If nearly 80% (which by now is surely more than that) of consumers prefer digital copies of games over physical… and retailers can’t sell digital forms of games anymore (at least from Sony)… that’s a giant red flag for the retail video game market.

There’s no one affected more by this trend and tipping point than GameStop.

The company is to video games what Toys “R” Us and KB Toys were to toys in the 90s. It is still a profitable business. Don’t get me wrong.

There are enough gamer unaffected by these changes to stay in business for years to come. You can still go buy a digital version of an Xbox or Nintendo Switch title. And there are plenty of ancillary products (controllers, accessories and preowned games) to sell. But the tides have already turned from growth to loss.

GameStop announced its fourth quarter financial results on Tuesday. For the full year 2018, global sales from continuing operations fell 3.1%. The company also announced it expects that to unfortunately accelerate throughout this year to between a 5% and 10% loss for fiscal 2019.

These numbers don’t necessarily support some of the fear-mongering in the financial media about GameStop, however. Headlines like “Can GameStop Survive Cloud Gaming?” and “Will GameStop Ever Turn Things Around?” clutter news feeds for the company.

As noted, the company does more than sell digital copies of PlayStation games. There will always be demand for all else it does. And Sony isn’t the whole market. So, the company isn’t on its last legs just yet. Investors have beaten it down like it was, however.

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Less than four years ago, shares of GME were trading at more than $45. Now, as you can see, they are under $10. The most recent financial release has even sent them briefly below $9 for the first time in a decade and a half.

So, how should one play this kind of madness?

We have an incredibly compelling side of the story about GameStop’s whole livelihood being pulled out from under it with Sony’s decision and the financial media’s insatiable appetite for hyperbole.

We also have a company that has a near monopoly on the retail side of gaming and millions of loyal customers, hundreds of stores offering thousands of products unaffected by the latest move and a depressed share price.

Fortunately, for options investors, there’s a way to play both sides at once.

A Strategy For GameStop’s Volatility

A long straddle is a type of options trade that involves buying both a call option and a put option on the same equity, with the same strike price and the same expiration date. Sounds nuts, right? Well, if your goal is to play price movement size over direction, it makes perfect sense.

You see, it doesn’t matter which direction a stock like GameStop heads from here. If shares continue to decline following its recent financial announcement, the put option in this trade will make money. If shares do somehow reverse – possibly because of the company’s now ludicrous dividend yield, its debt reduction and share repurchase plan announced last month – the call option will profit.

Either way, if the move is large enough, one of the two option contracts will profit far more than the cost of the other. The only way for this play to lose any money is if shares stay exactly where they are when the investor opens the trade.

But as you can see, that risk is limited:

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Source: The Options Industry Council

You can also see in this graph that the potential profit – no matter which direction the stock goes in – is near limitless.

Let’s look at a specific example of this kind of trade on GameStop…

A Specific Trade For GME

A trader looking to profit from GME’s bout of volatility could buy a May 17 $10 call option for $0.58 per share and a May 17 $10 put option for $0.65 per share for a total cost of $1.23 per share.

Since each contract is worth 100 shares, that’s a total net debit – and therefore total amount at risk – of $123. Considering the amount this trade could make, that’s chump change.

Consider this: if trends reverse and shares rally after this disappointing to financial release, a $15 GameStop would turn a profit of $3.77 per share… or $377 total. Likewise, a continued decline to say $7 would be worth $177.

To find these numbers, take the difference between the end price of GME shares and the strike price. Then, subtract the entry cost [($15 – $10 = $5; $5 – $1.23 = $3.77) OR ($10 – $7 = $3; $3 – $1.23 = $1.77)]. Then multiply by the 100 shares each contract is worth ($3.77 x 100 shares = $377; $1.77 x 100 shares = $177).

As you can see, the more GameStop’s share price moves, the greater the profit. And with so much going on at the company – and in the heads of investors surrounding the company’s share price – you can expect major moves like we’ve seen continue.

And the best part is… you don’t even have to know which direction those moves will head to profit.

— The Option Specialist

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