How options traders are driving the stockmarkets

Ordinary investors in the US are increasingly turning to options. And that's making the markets very volatile.

Have US equities pulled off a “healthy correction”? The Nasdaq index entered official correction territory last week after falling by more than 10% from a recent high. Yet US stocks started this week in better spirits. Optimists say that occasional pullbacks of this kind are needed to keep the market on its toes and get rid of “froth”. The idea is that occasional losses punish speculators who would otherwise leverage themselves up to the hilt betting on rising prices. That forces investors to remember the fundamentals and paves the way for a more durable rally. 

Too much froth

The trouble is that there is still plenty of froth around, says Bloomberg. The recent mini-crash wiped $2trn off stock valuations, but trading data shows that bullish retail investors, who often buy in through apps like Robinhood, remain “unbowed”. As Tom Essaye of The Sevens Report newsletter puts it, the recent pullback was “not even close to scary enough” to give people second thoughts about “buying the dip”. 

Ordinary investors are increasingly turning to options to play the market, say Andrew Bary and Avi Salzman in Barron’s. Option volumes in single-stock equities were up 80% in August compared to a year before. Call options, which give investors the right but not the obligation to buy a stock at a particular price in the future, are proving especially popular. Starting from as little as a few dollars, they enable investors with limited funds to make leveraged bets on stock movements. Some of these instruments amount to little more than “lottery tickets”. The vogue for options trading has wider consequences. As The Economist notes, such derivatives have been dubbed “weapons of mass destruction”. The finance houses that sell call options expose themselves to the risk that the shares will rocket higher, so they buy some of the underlying shares themselves as a hedge. If the price rises, they need to up their hedge. The result can be a “euphoric” feedback loop, with higher prices forcing more purchases and yet higher prices. The result? More volatility in markets on the way up and the way down.

Solid fundamentals?

For all the froth, the tech stock rally is still based on sound fundamentals, says Michael Mackenzie in the Financial Times. There are few alternatives to the earnings growth on offer from tech shares. Such innovators and disruptors are far better able to adapt and prosper in a world where everyday life is changing rapidly. Comparisons with the long profits slump after the 2008 crisis are unwarranted. Analysts expect a rapid earnings recovery once the crisis is over.

But the tech giants are not growing like they used to, says James Bartholomew in The Daily Telegraph. On 37 times earnings Apple’s shares look rich. It is a sign of the times that commentators increasingly talk about tech shares as a multiple of sales rather than profits. No one knows where big tech stocks go from here, but “I have no doubt that at least some of them are seriously overvalued”.

Recommended

The MoneyWeek Podcast with Russell Napier at the Library of Mistakes
Investment strategy

The MoneyWeek Podcast with Russell Napier at the Library of Mistakes

Merryn talks to Russell Napier about Edinburgh’s Library of Mistakes, the age of debt and financial repression, plus why he has never invested in Chin…
27 May 2022
What to buy as the tech-stock bull market crashes
Tech stocks

What to buy as the tech-stock bull market crashes

The decade-long bull market in tech stocks has come to a rapid halt. Investors need to distinguish solid stocks from speculative ones rather than just…
27 May 2022
What sardines can teach investors about today's markets
Investment strategy

What sardines can teach investors about today's markets

A California tale of “eating sardines” and “trading sardines” can help us divide investments into speculative and real, says Merryn Somerset Webb. Som…
26 May 2022
Is it time to pick up growth stock bargains yet?
Investment strategy

Is it time to pick up growth stock bargains yet?

If you’re thinking of picking up some bargains from the tech stock crash, beware – there are still plenty of “growth traps” out there. John Stepek exp…
26 May 2022

Most Popular

The world’s hottest housing markets are faltering – is the UK next?
House prices

The world’s hottest housing markets are faltering – is the UK next?

As interest rates rise, house prices in the world’s most overpriced markets are starting to fall. The UK’s turn will come, says John Stepek. But will …
23 May 2022
The Federal Reserve wants markets to fall – here’s what that means for investors
Stockmarkets

The Federal Reserve wants markets to fall – here’s what that means for investors

The Federal Reserve’s primary mandate is to keep inflation down, and lower asset prices help with that. So, asks Dominic Frisby – just how low will st…
25 May 2022
Should you be worried about energy windfall tax proposals?
Energy

Should you be worried about energy windfall tax proposals?

Calls have been growing for a windfall tax on UK oil and gas producers. It's a popular idea, but is it a good one? And what does it mean for investors…
24 May 2022