60-second Summary
The stock market set several new records this year. Fastest index decline. Shortest bear market. Fastest recovery. These are just a few of the headliners, but behind the scenes, many other important records are being obliterated. For example, the ratio of single stock options vs shares being traded has flipped for the first time ever. And it is a Big Deal.
Tell Me More
Options have been around for a long time. But haven’t been very popular with retail investors until recently. In short, an option is a contract to buy or sell (or do neither) an underlying asset in the near future. I will focus on buying (call options) to keep things simple e.g.
You think the price of $TSLA will rise over the next month, and want to make a quick buck. It’s currently valued at $100, and you think it will increase within the next 30 days.
You find a broker that’s willing to sell you a (call/long) options contract for 100 shares of Tesla for a cost of $1,000 (vs $10,000 for the actual shares). This contract gives you the option (but not the obligation) to buy those 100 shares at the cost of $100 each within the next 30 days.
If somewhere within those 30 days the stock prices doubles, you can decide to exercise the contract and buy 100 shares at $10,000 instead of the $20,000 they’re now worth. If you sold those stock you’d have a profit of: $20,000 - $10,000 - $1,000 = $9,000
However, if the price dropped to $50, you wouldn’t want to buy the shares at the cost of $100 each so you’d let the contract lapse. If you’d owned the actual stock, you would’ve lost $5,000, but with the option, your loss is capped at the value of the premium, i.e. $1,000
The low-cost, and potentially high rewards, make options very attractive. Especially to those with less experience, and bolstered by the recent success of other options traders. And that is where we are today.
New low-cost, highly accessible trading platforms mean that just about anyone (of legal age, or smart enough to get around the law) can trade options. We also recently found out that SoftBank has jumped into the options trading pool with billions of dollars. And whilst this is interesting, it only accounts for some of what has been driving markets higher.
You may have heard the adage “for every buyer there is a seller”, but what’s less obvious is that every institution that is facilitating options trading will hedge. If you buy a call (long) option for 100 stock of Tesla, your broker is likely to buy some representation of those 100 Tesla stock so that if you do make good, they don’t lose anything. And so in some cases, stock volumes are artificially increased (buy and sell) as part of the lifecycle of synthetic financial products we’ve created.
Therein lies the rub. On top of the stimulus; the retail bros; high-volume algorithmic traders; technology businesses gaining larger market share etc., a record number of options are being traded (~1000% more since 2000), and they artificially increase/decrease prices at lightning speed. This is excellent news for a particular portion of the world’s population in the short-term but is likely to hurt a lot of people in the longer-term.
How Can I Make Money From This?
Being successful in the stock market requires a few rare attributes, but it also helps to have an understanding of how other market participants are acting and thinking. Knowing that a large part of the market’s participants are new, and that option trade volumes are at record highs tells you that the general market is going to be incredibly volatile.
Despite this, good-value businesses are still good-value businesses, so don’t let the insanity of the current market conditions scare you out of well-researched positions. On the flip side, it may be tempting to trade those stocks being driven higher by momentum. But if you understand why they’re being driven higher, you’ll see that a slight turn in sentiment will bring those houses of cards crashing down.
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