Why Options Investors Should Avoid Meme Stocks

Investing using options is very different from constructing a classic long-term buy-and-hold portfolio. 

In this segment from Motley Fool Live that first aired June 7, Motley Fool Canada analyst Jim Gillies and Fool.com editor/analyst Ellen Bowman discuss why meme stocks are the absolute wrong choices for options strategies.

Ellen Bowman: Actually, talking about GameStop (GME -3.94%) and the nine years thing is a good segue into number 2, which was we did long-term, even as we used short-term strategies. It says here in the article, most people think options are exclusively short-term vehicles, but they are not. GameStop, Nokia, what's the longest running strategy we ever had in Motley Fool Options? Do you remember? I want to say something was more than a decade, something had been in there for more than a decade.

Jim Gillies: IBM was running for, I think seven years under me, unprofitably by the way, but it's another way of actually looking at options. There is a type of option strategy, Fools, called a synthetic long, which involves selling the longest put option you can find, taking the money. A synthetic long is a wildly bullish recommendation. I think the stock is undervalued and it's going to go much higher. To express that, it's a strategy of pure leverage. Sometimes, you might even get paid to set it up. It's pure leverage, wildly bullish. So you better be right. You best be right.

Bowman: That's why you're doing it this way as opposed to just buying the stock and holding it. You're saying, "I'm so convinced."

Gillies: I'm so bullish.

Bowman: "That I'm going to risk anything out of pocket right now. I'm not going to pay anything out of pocket right now. I believe this is going to go straight to the moon."

Gillies: Yeah, [laughs] which, again, meme stocks recently. [laughs] By the way, all of the meme stocks are terrible thoughts for this type of strategy. Well, because that's something that we were laughing at our friend Jim Mueller before, but it's something, the topic Jim and I have talked about many times, is the concept of process oriented outcomes. You can have a great process and have a suboptimal outcome. You can have a terrible process and yet get an amazing outcome. I'm going to humbly suggest that what's going on right now with AMC, the meme stock guys there, or BlackBerry, if you want, and I'll pick on one of Canada's fallen heroes, GameStop. I'm going to humbly suggests that what's happening with those stocks, with the 12, 15, 20 percent daily rises or higher, followed by 15, 20 percent daily drops, that is people playing games.

Bowman: Oh, yeah, that's gambling.

Gillies: It's gambling. I like my investing and particularly my options investing to be boring.

Bowman: Yes.

Gillies: When you are seeing stocks going all over the place like that, because again, options, they are leveraging instruments, they are derivatives. Let's say you have the good fortune to have a position on one of the meme stocks and you're playing with options, and the meme stock shoots up 30 percent.

Bowman: Right.

Gillies: I'm just picking a random number. It's a good bet if you've positioned yourself with the meme stock to benefit from crazy upward moves, if the stock is up 30 percent in a day, the options will be up 100, 150 percent in a day. That's a good day.

Bowman: Reasonably good return, yes, for a day.

Gillies: It's a reasonably good day. Again, it's very nuanced and complicated because what's the strike how far out is that? How far did you do before, above or below the money? But the problem becomes, on the day when the stock drops 25 percent in the day and you bought it yesterday. You bought the option yesterday, set the strategy yesterday. If a stock's down 25 percent, the Options strategy could be down 80, 90 percent in a day. That's a less good day.

Bowman: Slightly. You're probably going to be a little bit angry on that day.

Gillies: Some people don't mind. You called it gambling earlier, I concur, and some people don't mind gambling apparently.

Bowman: One thing we want to make, at least for Foolish style investing. I have been known to play a slot machine, I don't do that with my investment money. There's recreation and then there's what you're putting toward the future with some thought into it. I think that a lot of what were seeing, certainly with the meme stocks, we've stressed this all over the place, is people are just maybe being bored, who knows what. They like the ups and downs, they like to ride the ups and downs. Don't do that with options because as Jim is saying, they're derivatives. Everything you do will be multiplied either maybe, possibly, you'll become the meme stock millionaire, probably not. [laughs] Probably you're going to be walking away going, "Oh my God, this is 100 times more." Every option for those watching who don't happen to know this, every option you buy controls 100 shares of stock. If you're out there playing with a lot of leverage, there's a lot of danger you can get yourself into.