Love it or hate it, Reddit is back! Yesterday, Rocket Mortgage (NYSE:RKT) stock spiked 70% as members of Reddit’s r/WallStreetBets turned their attention to the Detroit-based online mortgage firm. With that, we saw several lucky souls supposedly have their net worth rise anywhere from $180,000 to $1.4 million in less than four hours.
Source: Lori Butcher / Shutterstock.com
Sorry, Wall Street. You’ve lost again to retail investors.
After all, Rocket Mortgage has all the ingredients to create a Reddit-driven short squeeze: 40% short interest, an active options market and a name that would make Elon Musk’s SpaceX’s program jealous.
But as RKT’s market value declines back to $60 billion, should you buy the dip? Absolutely not.
The $30-35 range, after all, is still a handsome 40% premium to its original price. Instead, smart traders should look to the options market to make some money. Because with Wall Street focused on the next potential short-squeeze of the century, Reddit investors could be making easy money elsewhere instead.
Investors from r/WallStreetBets generally favor a relatively simple, yet highly effective weapon: out-of-the-money call options. (For the uninitiated, these are wagers that a stock will exceed a specific price before a certain date). These low-cost bets ordinarily go to zero, but the occasional winner will bag their owners thousand-percent returns. Prices for $34 3/5 RKT calls, for instance, jumped from 60 cents to $11.19 on Tuesday.
Any investor who put in $1,000 would have walked away with over $53,000.
However, a problem happens when call-option winners start posting their gains online — something made possible by Reddit and other social media outlets. As word spreads about early investors’ super-normal profits, others start jumping on the bandwagon, hoping that a delta-gamma squeeze will send shares even higher.
Often, this strategy works beautifully. Anyone buying GameStop (NYSE:GME) options during its first run-up could have become an overnight millionaire if they bought out-of-the-money calls with >$200 strike prices. But sometimes, the strategy can fall flat. For example, look at $30 AMC (NYSE:AMC) calls. They’re virtually worthless today.
The r/WallStreetBets call options strategy is much like playing a high-payoff lottery: it’s excellent for betting small amounts of money, but many get addicted and end up gambling more than they can lose. That’s why most market commentators will find themselves tongue-tied when advising Reddit investors whether to buy more $GME or other meme stocks. Things can go either way.
But there’s also a flip side — these price lurches make easy wins possible for regular investors.
In theory, rocketing prices should only affect call options premiums. Fears of a GameStop repeat will have options sellers asking for ever-greater margins to cover the risk of a second spike. Today, it’s impossible to buy any option with a good strike for less than 60 cents.
But in the excitement, put options also get swept up. On Tuesday, implied volatility (IV) for RKT puts — a measure of put option prices — rose from 0.9 to 2.4. That far outstrips the 2.0 IV of call options. Much of this is a supply-demand problem. Wall Street firms that believe RKT stock will eventually sink back to the $20 range will snap up put options faster than market makers can sell them. But some of it also comes from retail investors looking to either cash in or protect their gains.
But wily investors should sense an opportunity. Thank you, Reddit! It’s time to make some easy money.
The easiest way to profit from high IV is by selling far out-of-the-money puts. $16 puts expiring next week currently sell for 10 cents per contract at the time of this writing. Their implied volatility sits at over 2.0, making them abnormally pricey from a theoretical standpoint. And given Rocket’s strong fundamentals, the firm’s chances of falling below $16 by next week is vanishingly small.
Investors looking to cover downside risk could even buy lower-priced puts. That will help close out losses if RKT stock sees a catastrophic fall (i.e., if the headquarters building burns down or massive fraud gets exposed).
Just don’t sell naked calls. While it’s generally easy money to profit from high IV, the strategy exposes you to unlimited losses. Closing out that risk by buying the underlying opens you to even more troubles if prices go back down.
Back in August, I wrote that Rocket Mortgage should fundamentally be worth $22 if the company expands Net Operating Profit (NOPAT) from 11% to 14% and maintains an 11% growth rate. And if the company can push its growth to 20% (something quite possible in a growing fintech world), its fair value would jump to $45. Rocket Mortgage is a high-quality company that deserves a $50+ billion valuation.
Eight months later, these price predictions still hold. Expected sales growth, however, has not.
Analysts now expect Rocket Mortgage’s revenues to decline 25% in 2021, followed by another 16.5% decline in 2022. Rock-bottom interest rates would dry up the refinancing market even as more pandemic-weary Americans buy new houses. And although growth will likely recover faster than analysts expect, investors should still price the stock’s fair value at the conservative low-end.
In other words, buy-and-hold investors need to wait for sub-$25 prices before jumping back in.
Meanwhile, the options market provides a great way to play RKT stock: buy out-of-the-money calls or sell deep out-of-the-money puts in amounts that makes sense for your wallet. There’s a lot of money to be made for those willing to take the gamble.
On the date of publication, Tom Yeung did not have (either directly or indirectly) any positions in the securities mentioned in this article.
Tom Yeung, CFA, is a registered investment advisor on a mission to bring simplicity to the world of investing.
The post Reddit Isnâ€™t Done With Rocket Mortgage. You Can Profit As Prices Dip. appeared first on InvestorPlace.
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