Options Feedback Loop Revives Bust Warnings in Soaring Stocks

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As stocks extend their relentless rally from last year’s bottom, one measure in the options market is flashing a warning signal.

Over the last 30 days, an average of more than 22 million calls traded across U.S. exchanges — close to a record, data compiled by Bloomberg show. That’s forced the dealers selling those contracts to buy the underlying shares to offset any option price drift, boosting their potential selling pressure to an all-time high, according to at least one model.

To some, the feverish call-buying is fueling a bullish feedback loop in equities as market makers hedge their positions. Retail traders have stoked the frenzy, with JPMorgan Chase & Co. analystsnoting that small-trader call option buying has rebounded abruptly after December’s seasonal dip. As signs of froth and bubble warnings abound, stock markets may be setting up for an intense gamma squeeze, according to Susquehanna International Group. For some analysts, Friday’s index option expiry will bring a test to the market.

“Dealers are short calls due to the unprecedented call activity previously mentioned, and as a result have been forced to chase stocks higher to hedge,” Chris Murphy, Susquehanna’s co-head of derivatives strategy, wrote in a note to clients. “The unwind could potentially be violent given all the excess euphoria. It is more likely a question of when and not if.”

That euphoria has morphed into a full-blown mania just days into 2021, with retail darlings such as Bitcoin andTesla Inc. soaring 37% and 20% respectively already this year. But perhaps the most dramatic illustration of the day-trader craze came on Monday, when six stocks priced under $1 per share made up nearly a fifth of total U.S. volume.

That’s in addition to the money traders have been shelling out in the options market. Over 18 million calls in sizes of 10 contracts or less were purchased in the first week of December, the highest ever, according to the Options Clearing Corp. data compiled by QVR Advisors Chief Investment Officer Benn Eifert. Just over 16 million calls were purchased in the first week of January.

That’s pushed so-called gamma exposure to an all-time high, according to one measure that not every analyst considers gospel. It could climb even higher, with the President-elect Joe Biden’s administration poised to usher in a new round of fiscal aid.

“There will be checks, that will likely spur even more frothy weekly options trading,” Peter Tchir, head of macro strategy at Academy Securities, wrote in a note to clients. “The put/call ratio is as low as it has been, and my social media streams are literally ‘blowing up’ with daily and weekly options trading strategies.”

A similar dynamic was seen in late summer. The degree of call buying concentrated in megacap tech names was theorized to help power the Nasdaq 100 higher by 73% from the depths of March through the end of August. However, the so-called gamma hedging boost was also through to exacerbate September’s 5.7% drop, given that dealers who sold the options likely had to unwind their hedges at an increasing speed, spurring more losses.

Whether this episode ends in a similar fashion remains to be seen, but traders are bracing for Friday’s index option expiry. Between options on the S&P 500 and the $334 billion SPDR S&P 500 ETF Trust (tickerSPY), roughly $4.2 billion of gamma exposure lies at the 3,850 on the S&P 500, from current levels near 3,800, according to Charlie McElligott, a cross-asset strategist at Nomura Securities. Roughly 35% of that sum is set to roll off on Friday, potentially eroding a buffer of sorts, he said.

“Substantial amounts of the currently ‘insulating’ dealer hedging flows will disappear, then opening us to larger price movement thereafter,” McElligott wrote in a note to clients.

— With assistance by Vildana Hajric

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