Cover Your Options

You — or least those of you paying attention — know how much I love irony so I’m delighted to report that we got a classic example last week when an “investor” filed a class action in Boston against a guy who touted shares of GameStop to create the runup in the stock price.

I put “investor” in quotes because I was doing the air quotes motion while typing this. It made me feel cool and ironic. I also do it because it’s kind of hard to call what this guy did investing. I’ll explain that in a moment. Let’s first get to the irony.

What we have here is three law firms suing on behalf of people who would have profited if lots of other people who held GameStop stock lost money on their shares. Now they’re mad that they lost money instead.

The named plaintiff is a guy who sold options. The named defendant is a guy who bought options. For good measure, the investment companies that the defendant, Keith Gill, aka Roaring Kitty, worked for are named defendants too for not reining in the Kitty. (Bad Kitty!)

I’m not going to defend either side here but, again, irony. All you have to do is look at the description of the named plaintiff. He’s a random guy from Washington with very little social media presence so we don’t really know anything about him who gets to represent the hedge funds who just maybe would like to see this kind of suit do well.

And he’s described as someone who sold $200,000 worth of call options on GameStop and then lost money because the defendant rallied investors on the internet to pump up the stock.

How is that possible? None of the news reports of this suit that I saw explained this, so I’ll do it. It means he sold uncovered calls.

If you don’t know what that means, allow me to explain. There are two kinds of stock call options you can sell: covered and uncovered. If you sell covered calls, that means you own the underlying stock and if their price goes way up, you miss the rally profit but you don’t lose money. All you have to do is turn over the stock you own at your call option strike price while you keep the premium you got for selling the options.

But if you sell uncovered calls, that means you didn’t own the stock. If the stock price goes up, you have to buy the stock at its current price if the options get exercised and then turn them over to the option holders for their option “strike” price. In other words, you can lose a lot — to infinity and beyond!

The random plaintiff took in $200,000 hoping to keep it when and if regular stockholders lost a ton of money. A guy like this is not a regular stockholder. That’s not investing — that’s gaming. Do not pity this fellow.

I should also note here in case you don’t already know that options cost a fraction of the price of their underlying stocks. We don’t know the details of this plaintiff’s trade, but it sure looks like this was a very big bet. Again, not a normal guy here.

The cynic in me (which is most of me) wants to think that the law firms who filed this suit really want to represent the hedge funds who got burned. One clue from the suit: “Gill slyly targeted large hedge funds who had shorted GameStop stock as the evil, powerful big boys.”

Ok, but is that wrong?

Gill’s alleged sin is that he convinced thousands of investors online to, in effect, pool resources to drive up GameStop stock while not disclosing that he’s a licensed broker. This is as opposed to hedge funds, run by licensed professionals, that pool resources (in a fund) to do what they want to do while not disclosing anything.

The only maybe good thing about this is that the proposed class includes individual GameStop stock purchasers during the runup period —a lot of whom probably lost money when the stock came crashing back down after they were told to hold on. My guess is that they’re not going to get a lot of attention.

What’s the moral of all this?

Cover your options and take cover.

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