GameStopRocket-fueled trading this month, which took 2021 stock’s gains above 1,000%, is a vivid example of how a new army of day traders has ‘militarized’ financial derivatives to their advantage.
During pre-market trading on Wednesday, the game retailer’s stock catapulted above $ 300 at one point, more than doubling from Tuesday’s closing level, after ending 2020 below 19. $ the share. It recently traded at $ 260.
A user with the nickname DeepFuckingValue on the popular Reddit WallStreetBets forum published screenshots Tuesday, showing how he turned around $ 50,000 in GameStop call options – which give the holder the right to buy a stock at a certain price and work much like a leveraged bet – into nearly $ 23 million dollars this year.
Yet GameStop is just the most visible example of current options. stock market mania. While the increasing use of derivatives has been a hallmark of previous retail frenzies – like the dotcom boom of the late 1990s – the current popularity is alarming even to seasoned observers.
“What we’ve seen in the last few trading sessions verges on madness,” said Steve Sosnick, chief strategist at Interactive Brokers. “You can still do crazy things in individual actions, but when you see it metastasizing to a whole range of other actions, it’s a sign of real foam.”
Options are particularly powerful trading tools, as they can be used to bet on and against financial securities, and can amplify returns and losses, which has made them extremely popular among the new generation of traders. retail traders.
In exchange for a premium, calls give holders the right to buy a share at an agreed “strike” price on a certain date. Putts give the right to sell at a certain price and work as insurance against drawdowns. But on Internet forums, there is above all only the appetite for calls for actions that are rising “to the moon”, as the common refrain says.
More worrying to some analysts, the more sophisticated traders also seem to actively exploit some of the unique characteristics of options, often denoted by Greek letters such as “delta” and “gammaBy professionals on Wall Street, and use them to drive up prices.
In a series of articles, the FT examines the exuberant start of 2021 in global financial markets
Option trading volumes have exploded over the past year, but the rally has been particularly strong in small trades of 10 call contracts or less – typically the type of trade size dominated by retail investors rather than by large institutions.
The amount spent on premiums for call option trades of this size declined last fall after a a record summer frenzy, but has now returned to nearly a record high of $ 34.2 billion on a rolling four-week basis, according to a study by Jason Goepfert of Sundial Capital Research.
The reason that options can have a disproportionate impact on the underlying stock is because of their unique dynamics. The seller of an option, usually a bank or other large financial institution, is obligated to deliver the promised shares if the strike prices are triggered, or to buy the shares in the case of the put options. Brokers will therefore continually hedge by buying – or selling – the underlying security.
This can trigger feedback loops, especially when stocks start to approach the strike price and banks are forced to cover their “gamma” exposure – as it is called in the jargon of traders. Gamma measures how much the price of an option accelerates when the price of the security on which it is based changes.
Some analysts and investors claim that many retail investors have learned that by banding together for whirlwind calls they can help drive the price of the underlying stock up to the strike price by forcing dealers to cover their own exposure.
“Armed gamma is a perfectly reasonable way to describe it,” said Benn Eifert, chief investment officer of QVR Advisors, a hedge fund. “You see a lot of sarcastic comments that these are just stupid people. But there are clearly sophisticated, intelligent, and thoughtful people who do this too.
Mr Sosnick agreed and said feedback loops could become particularly powerful when dealer gamma hedging is combined with small stocks that have a limited proportion of freely tradable stocks and are subject to large short positions – such as GameStop.
“It’s like a colony of ants. Each ant may not be able to move a lot, but if you have enough it can move a remarkable amount, ”he says. “If enough people buy $ 40 calls on a $ 35 stock, market makers will eventually have to hedge. . . In the short term, you can make a real recovery. “
The question is to what extent these dynamics affect not only certain individual stocks, but the stock market as a whole. Analysts say the the retail frenzy has migrated big names like Apple, Google and Tesla that were popular last summer in more remote corners of the stock market, where the impact is more powerful but more idiosyncratic.
Nonetheless, the overall impact on the market of the options frenzy is likely to be “significant,” according to Chris Murphy, co-head of derivatives strategy at Susquehanna International Group.
“It’s not only the overall volume numbers – which are impressive in themselves – but it also has ripple effects on different parts of the market,” he said.