How Options Trading Could be Fueling a Stock Market Bubble
The stock market is near record highs and optimism is high. Coronavirus vaccines are finally being hugged. Interest rates are at historic lows. And the Democrats who control Washington are expected to pour another trillion dollars into the still troubled economy.
However, it is becoming more and more difficult to miss signs that investors are going too fast and too far.
The most recent signal comes from the somewhat dark stock options market, where traders with brokers can place bets on a stock going up or down. Speculation has reached frantic levels that have not been seen since the dot-com boom ended two decades ago. This craze has a growing impact on the regular stock market.
“When you wager on sports, the number of people on one side of the bet can only affect the odds, not the outcome,” said Steve Sosnick, chief brokerage strategist at Interactive Brokers in Greenwich, Connecticut. “With options, the result can actually change.”
Over the past year, and even during the deep uncertainty that shook the market at the start of the pandemic, individual investors – often with little experience – poured into the market. What attracted them is different: free trade, extra money from aid payments or even an itch when most sports leagues are closed.
Options trading hit a record in 2020 with around 7.47 billion contracts traded, according to Options Clearing Corporation. That’s a 45 percent increase over the previous record set in 2018.
Much of this money comes from small traders hoping to make quick wins that will expire quickly by buying “calls” – betting on emerging markets.
The offset is reflected in the so-called put-call rate, which shows how many contracts bet on profits compared to those that bet on losses from put options. On Friday, the 50-day moving average for this ratio was 0.42, close to its lowest level in two decades. The last time it was this long was in 2000, meaning options investors are more optimistic or greedy than in over two decades.
Together, the sudden growth in options trading and the unbridled optimism of buyers are a market-moving force in itself.
How options can drive the market.
A person who wants to bet that a stock price will go up can buy a call option from a brokerage firm. This contract gives the buyer the right – but not the obligation – to buy a share at a certain price at a later date. If the share price is higher on that date, the buyer can buy the shares through the contract and then sell them for a profit.
Business & Economy
Jan. 22, 2021, 7:23 p.m. ET
But just as the buyer can benefit from a rising stock price, the dealer who sold the contract will lose.
Brokerage firms make money by charging for products and not predicting where stock prices are going. To hedge your risk on a particular contract, buy a calculated percentage of the stocks that you would have to sell if the buyer made money on the bet.
But when stock prices rise, brokers need to buy more stocks to keep their hedges balanced. Buying more shares will help drive share prices higher.
In other words, rising stock prices will fuel demand for stocks even further, all because of market dynamics – not a fundamental view that the company’s business prospects are improving.
“In this situation, traders intensify price movements,” said Andrea Barbon, assistant professor of finance at the University of St. Gallen in Switzerland, who recently wrote a co-wrotea paper that analyzed the relationship between options markets and market volatility .
The result can be an options market that has itself become a generator of price momentum and stocks that seem increasingly disconnected from fundamental fundamentals such as corporate earnings expectations.
“The basics are not the driving force. That doesn’t matter anymore, ”said Charlie McElligott, a market analyst at Nomura Securities in New York. “It is the size and growth of the options market as this lottery ticket vehicle that is currently being expanded with the retail hype.”
Will the market correct the price hike?
The overwhelming optimism of stock option investors – and the possibility that they are fueling a feedback loop of rising stock prices – is one of the reasons some analysts fear a bubble may form in the market.
As a rule, when the story is a guide, such bubbles don’t last. The rush in 2000 was followed by a downturn of around two and a half years when the stock market fell 40 percent.
The downturn doesn’t have to be this dramatic. Last August, the put-call rate rose sharply when the upward movement took hold.
Shares suddenly fell in early September, and the S&P 500 fell more than 7 percent in three weeks. The sell-off was led by the same giant tech companies – including Microsoft, Amazon, and Alphabet, Google’s parent company – who led much of the market’s month-long rally.
Few analysts saw a fundamental reason for the decline.
“There is usually a lot of speculation going on,” said Sosnick.
Right now, however, there is little evidence that investors have felt fed up.
Since the sharp setback for tech stocks in September, retailers have doubled their interest in buying single stock options, which has become especially popular with online amateurs who gather on Reddit and Discord to share ideas and see screenshots of supposed profits and guts Wrench losses.
The momentum is likely to continue until the markets fade and these newly-minted traders suffer painful losses that for many will be the first in an extremely short career as an investor.
“Are these the types of people who have the ability, acumen, and pain tolerance to stay disciplined and not create a rush of new investors out the door?” Mr. McElligott asked.
If they flee, it would only add to a fall.
“It can get flammable there,” he said.