In recent months, the stock market has been, to use a technical term, bizarre. This is due to more than the usual buzzing volatility of a bull market top.
The markets have been punctuated by wild jumps and crashes with improbable names, from unwanted stocks such as GameStop to established companies such as ViacomCBS, after being drawn into the Archegos debacle.
The shadow cast by the stock options market is one of the factors behind many of the strangest market episodes.
The volumes of stock options have jumped in recent years. According to the NYSE, the average daily volume of stock options and exchange-traded fund trading increased from 17.5 million in 2019 to 27.7 million in 2020. This year, the market is in tune with more than 40 million contracts.
This matters to those who are still trading the boring old stock market, as all of those options to buy and sell stocks need to be covered by the dealers who are offering them.
For “call” options to buy stocks, brokers often do so by buying the underlying stocks. In jargon, the amount of shares that a broker must buy to cover an option is the option’s “delta”. The delta depends on the probability that the stock will reach the option strike price and the option’s expiration date.
Here is the tricky part. The delta of an option changes with the price of the underlying stock. So if a stock really does start to go up, options brokers need to buy more to cover the options they’ve sold. This adds to the upward pressure on prices, pushing stocks higher and forcing dealers to buy even more stocks, which in turn. . . well, you see where it goes. That kind of snowball was behind the most violent spikes GameStop, a name in which buyers of retail options have stacked up heavily.
The bottom line is that the state of the stock options market at any given time tells you something about the pressures that will eventually be felt in the stock market itself – and it should be possible to trade on that fact. .
The rather unlikely standard-bearer of this type of business is Lily Francus, in her twenties with a doctorate in bioinformatics. Until recently she was an amateur trader, but her funny and lucid social media and blog posts have earned her a media presence, and she now trades for a living.
The basic concept of Francus is an indicator called Nope – “the net price effect of options” – which is a rough gauge (or as she puts it, “by hand”) of the weight that the options market exerts on. the action. market. It estimates the amount of liquidity available in a certain stock or index that is absorbed by options traders hedging (this is only an estimate, as brokers have other ways of hedging than by hedging). buy the shares). It is calculated as the delta of all outstanding “call” options to buy shares, minus the delta of all “put” options to sell them, divided by the total daily trading volume of the shares.
When Nope gets abnormally high, says Francus, “the market has a strong tendency to reverse.” His explanation is that as a stock moves quickly and option dealers stack up to make sure they’re covered, it pushes the rally to the extreme. But when the rally finally wears off, options dealers suddenly stop buying, and the market quickly reverts to average.
Lily Francus Says “No-Behavior” In The Market Took Off In 2018
“When the volume linked to options represents a large share of the market, it makes the market unstable,” she sums up. Keeping an eye on Nope can, in theory, help you choose which rallies to sell (this seems to work for routs too, but not as reliably).
This encouraging character of options volatility is a nice iteration of a familiar Wall Street irony: a financial instrument designed to manage risk is transformed into a speculative device, which makes the market riskier. Two other good examples are credit default and total return swaps.
The increase in the volume of options and levels of Nope in recent years also demonstrates the multifaceted nature of risk. When deleted in one area, it appears in a different form elsewhere.
Francus points out that “no behavior” in the market took off in 2018, after Credit Suisse to close its huge XIV fund, which offered traders a way to bet on market volatility. The fund was crushed in a market rout early this year known as “Volmageddon. But traders just turned to the traditional, highly leveraged way of trading market volatility: the stock options market.
With Nope, Francus crystallized a concept that could allow us to better understand the volatility of the markets. But the appetite for dangerous levels of risk, especially in bull markets, will persist.
robert.armstrong@ft.com
