How options traders are driving the stockmarkets

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.

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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”.