HOW OPTIONS ARE FUELING THE MARKETS – August 16, 2021
In the past week, we have seen the Nasdaq and the S&P reach all-time highs. Since the covid crash, we have seen some massive movement to the upside. I believe there are several factors driving these markets up.
First, let’s look at the covid crisis and how it played a role. As a result of the shutdowns, the FED took a really aggressive stance with its quantitative easing measures. Lots of money printing to pay for massive stimulus payouts. The worse news we hear historically is that the markets will react sharply to the downside.
In this market, they did the opposite because many in the market viewed the bad news as a sign the FED will keep its foot on the gas with their aggressive quantitative easing. The markets love this as they see it as huge economic growth with less risk, even when things were shut down. Many people were at home and had nothing to do but spend their stimulus money. The markets loved this. That is why we saw massive growth in AMZN, FB, GOOGL, and MSFT. Other stocks favored from staying at home were ZM, NFLX, and TTD.
Now how do options fuel the markets? Well, when an underlying stock has options there is a secondary derivative market that has its own supply and demand outside of the stock. This can cause market makers to balance those demands. How do they do this?
They do this by taking the difference of the total contracts bought and sold and adjust accordingly. So for example let’s look at SPX. In the below picture you can see Put volume is roughly half the call volume. In this case, the market maker would engage in an activity called delta hedging where they would buy shares of stock to offset the difference between the Put and Call contract volume. Since the market maker is only interested in the arbitrage between the bid and ask of these contracts, they want to stay delta neutral or, in other words, not be affected by stock price movement. When they buy to offset, this can drive the price of an underlying stock up. This is one reason why so many traders watch unusual options activity.
Every day on we do defined risk trades that protect us from black swan events 24/7. Many may think that is what stop losses are for. Well, remember the markets are only open about 1/3 of the hours in a day. Therefore, a stop loss only protects you for 1/3 of each day. Stocks can gap up or down. With options, you are always protected because we do defined risk in a spread. We cover with multiple legs which are always on once you own.
Author: Chris Vermeulen