There are perhaps fewer things in investing more terrifying than retail investors armed with derivatives. It’s like giving a monkey a shotgun in a crowded room.
The influx of retail investors into the market at the onset of COVID-19 shutdowns has added an unpredictable element to the market. An abundance of naked call buying has unbalanced things, and could lead to trouble. The Economist explains:
Who bears most responsibility for the volatility? First, small-trader flow is much larger in size, although it was likely dispersed among more listed companies. Second, and more importantly, although both types of buyer purchased options, the trades differ greatly. The options bought by SoftBank are reported to be long-term (three- or six-month) bets on the biggest tech firms, like Amazon and Microsoft. They were also “delta-hedged”, as is typical for institutional investors, meaning that at the same time as SoftBank bought the options, its bankers also sold the underlying stocks in proportion to the exposure the option gave them. This is important, because it means that the marketmakers who sold SoftBank the options did not immediately have to hedge their position by buying up shares in, say, Microsoft or Amazon.
This is different to the type of option that retail investors typically buy, which is a call option purchased “naked”, ie without a hedge. Significant volumes of unhedged call options will force the marketmakers to buy up shares in the underlying stocks, creating a positive—and potentially euphoric—feedback loop. Adding to this dynamic is the short-dated nature of the derivatives. The value of an option that is short-lived moves rapidly as the share price moves. As expiry approaches, any increase in the price of the stock makes the option more valuable. Moreover, it means that the marketmakers who sold the option will quickly need to bolster the size of their hedges, increasing the upward momentum. These differences make it more likely that retail flows were a bigger driver of momentum in tech stocks in August than SoftBank was.
This heavy use of derivatives may also explain some unusual market dynamics. Because shares tend to inch higher steadily, but drop more rapidly, rising markets usually occur amid falling volatility. However, the leaps in share prices in recent weeks have caused the correlation between falling volatility and rising prices to break down for the first time since 2018.
What does this imply about the future performance of tech stocks? Because of the influential role of turbocharged retail investment, prices can be expected to remain choppy.
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