Have you seen what’s going on out there?
Here’s a trader who plowed a hefty $150,000 of his savings into Tesla TSLA options:
And then there’s this guy. He bet his entire IRA on options tied to tech stocks:
These gamblers dabbling with options are part of the tsunami of private investors who swept the market during Covid.
Wall Street used to laugh them off because they didn’t have enough cash to stir the market. They were mere fry compared to market whales like investment banks and pension funds — which own 80% of the stock market.
But as it turns out, small investors quietly exploited derivatives to “outinvest” Wall Street and became the rocket fuel that sent tech stocks to the moon. However, a pullback may be looming.
How options work in a nutshell
Options are contracts that you can trade on a stock exchange like any stock. They come in two forms: calls and puts.
Calls give you the right to buy 100 shares of stock at an agreed price until a certain date. When the stock rises, you make money. Puts are the opposite. They let you sell the stock at an agreed price — and act as insurance if the stock falls.
Most important here is that options give investors leverage.
For example, for $400 today you can buy a call contract that gives you a right to buy 100 shares of Apple AAPL at $112.5 until October 9. The same $400 would buy you just shy of 4 shares of Apple.
In other words, options give you the power to hold hundreds of shares for just a slice of the cost it would take to actually buy them. They also magnify your returns (or losses).
If Apple jumps to, say, $122.5 by October 9, you use your right to buy 100 Apple shares at $112.5 — which you then sell at $122.5. Take away the premium ($400), and you’ve pocketed $600 — a 150% gain.
Meanwhile, Apple shares would have handed you an 8% gain in the same situation.
Small investors are piling into tech options like never before
Institutional investors putting in large orders used to rule the options market. But in 2020, swarms of return-hungry mom and pop traders quietly threw them over.
Look at the chart below. As the market rebounded, small investors began snapping call options like there was no tomorrow:
In August, they bought 6X more call options compared to a year ago. In just four weeks (starting mid-Aug), they forked over a record $37 billion on calls, according to Sundial Capital Research
And get this, at one point individual investors made more than half of all options trades in the market — “outinvesting” even Wall Street’s whales. (Remember: they typically control 80% of the stock market.)
I’ve looked into what they bought. Here’s a list of stocks with the most active options (tech highlighted in yellow):
No surprise, 8 out of the top 10 stocks are household tech darlings — including high-flyers Tesla (TSLA), Apple (AAPL), and Nikola (NKLA).
Now here comes the most interesting part.
How average Joes became one of the market’s dominant forces
Small investors buying $37 billion worth of call options in four weeks is a lot by itself. But that’s a flyspeck compared to the gears these contracts started turning inside the market’s machine.
The Economist estimated that the contracts were tied to about $500 billion worth of stock. And even if investors didn’t exercise a single contract, they forced the option seller to buy some of that stock.
You see, options are sold by dealers called market makers. They are big financial institutions whose job it is to buy and sell securities like bonds, stocks, and options at all times. (In financial lingo: provide liquidity.)
If you want to sell a stock, they are there to buy it. If you want to buy a call option on Tesla, they’re there to sell that contract to you.
The problem arises when you want to buy, say, a call option, but there’s no seller for it. Then the market maker has to issue the contract itself. As such, if the buyer gets it right and the stock goes up, the dealer is on the hook.
Consider the same Apple example. In that situation, the market maker would have lost money. The contract would have forced it to buy 100 Apple shares at $122.5 and sell them back to the option holder at $112.5.
To dodge the risk, the market maker buys the stock as soon as it sells the call option (“delta hedging”). That means when private investors put a record $37 billion into options, money makers were forced to buy up to $500 billion worth of stocks. In four weeks.
Even a slice of that is a humongous pile of money — most of which ended up in tech stocks. For perspective, private investors bought just one-third as much net in all of 2019. Here’s what that looks like:
Such money can stir up tech giants even at historic highs.
What this all means for you
Tech had every reason to go up in 2020. Covid pressed the fast-forward button on many tech trends and puffed up demand for internet services. But the options craze may have driven the tech rebound beyond any reason.
What will happen when stocks wobble and kitchen table traders lose interest in them? And when money makers start selling hundreds of billions of dollars in hedged stock?
I wouldn’t rule out another pullback. And that would affect everyone — even those who hadn’t laid their hands on tech stocks.
As I wrote in Meanwhile in Markets…, tech makes up about one-third of the S&P 500. ETFs tracking this index are some of America’s most popular funds. They are also one of go-to retirement investments.
Even a dip in tech could drag all those funds down. And we recently got the taste of what that looks like.
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This is not investment advice.