How option trading can fuel the stock market bubble

The stock market is near record highs, and there is a breach of optimism. Coronovirus vaccines are ultimately converted into weapons. Interest rates are at historical lows. And the Democrats who control Washington are expected to pour another trillion dollars or so into the economy they are expecting.

But it is increasingly difficult to ignore the signals that investors are taking too far too fast.

The latest indication is from some obscure market for stock options, where traders can place bets with brokers as to whether the stock will rise or fall. Speculation has reached an insurmountable level since the tail end of the dot-com boom two decades ago. That enthusiasm has increasing influence on the regular stock market.

“If you’re placing bets on the game, the amount of people on one side of the bet or another can only affect the odds, not the result”, said Steve Soznik, chief strategist at Interactive Brokers in Greenwich, Conn. said. Brokerage. “In terms of options, it can actually change the outcome.”

Over the past year, and even during the deep uncertainty that fueled the market at the onset of the epidemic, individual investors – often with little experience – have been putting in the market. What they have been lured into: free trade, Extra cash relief payment or even An itch for action Most sports leagues closed.

According to Options Clearing Corporation, Options Trading recorded a record business in 2020 with contracts worth some 7.47 billion. This was 45 percent higher than the previous record, which was set in 2018.

Much of this money has come from small traders who are hoping to make a rapid profit by purchasing “calls” – bets on growing markets – set to expire quickly.

The skew is evident in something called the put-call ratio, which shows how many contracts are at a profit compared to betting on losses through “put” options. The 50-day moving average of that ratio was 0.42 on Friday, the lowest level in two decades. The last time it hooked up for this long was 2000, meaning investors are more optimistic, or greedy, for more than two decades.

The combination of sudden growth in options trading and unbridled optimism of buyers is itself a market-moving force.

A person who wants to place a bet that the share price is going to rise can buy a call option at a brokerage firm. The contract gives the buyer the right – but not the obligation – to buy the stock at a given price at some point in the future. If the share price is high on that date, the buyer can buy the shares using the contract, then sell them for a profit.

But just as the buyer stands to gain from the rising price of the stock, so does the dealer selling the deal stands to lose.

Brokerage firms make money by levying fees on products, not by predicting where share prices go. So to reduce their risk on a given contract, they buy a calculated percentage of the stock that the buyer must have forced to sell to make money on condition.

But as stock prices rise, brokers should buy more shares to balance their hedges. Buying more shares helps in raising share prices.

In other words, rising stock prices have increased demand for shares even more, all because of market dynamics – not because of a fundamental outlook that the company’s business prospects are improving.

“In this situation, dealers are ramping up price movements,” said Andrea Barbon, assistant professor of finance at the University of St.Gallen in Switzerland, who recently co-authored.a paper Analyzed the relationship between the options market and market volatility.

The result may be an options market that has itself become a generator of share-price momentum and shares that, like expectations for corporate earnings, appear increasingly disengaged from bedroll fundamentals.

“The basics are not drivers. It doesn’t matter anymore, ”said Charlie McElligott, a market analyst with Nomura Securities in New York. “It is the scale and growth of the marketplace of options as a lottery ticket vehicle, which has just been increased especially because of the retail frenzy.”

The overwhelming optimism of stock option investors – and the chance that they are sometimes filling the feedback loop of rising stock prices – is one reason some analysts are concerned that A. There may be bubble formation in the market.

If history is a guide, then such bubbles do not tick. The mania that came back in 2000 fell to 40 percent in the stock market after nearly two and a half years of decline.

The recession does not have to be that steep. In August, the put-call ratio gained momentum as the boom gained momentum. There was a sudden drop in stocks in early September, with the S&P dropping more than 500 7 percent in three weeks. Sales were led by a number of veteran technology companies, including Microsoft, Amazon and Alphabet, Google’s parents, which led to the market’s months-long rally.

Some analysts saw a root cause of the decline.

“High level speculation usually runs its course,” Mr. Sosnick said.

But for now there are some indications that investors have maintained themselves.

Since the sharp setback for tech stocks in September, retail traders have redefined their interest in purchasing single-stock options, which have become particularly popular among online amateurs who gather on Reddit and Disord And attract ideas and both alleged wins and pawns on the screenshots of intestines – pitfalls of peril.

The momentum will probably remain until the markets are closed and these new mining traders experience painful losses, for many, it will be a very short investment career.

“Are these types of people who have the ability, acuity, pain tolerance to stay disciplined and not create a stampede of new investors out the door?” Mr. McLigot asked.

If they flee, it will increase any deterioration.

“That’s where it can be combustible,” he said.

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