The stock market doesn’t depend on what you would think

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Did you see what’s going on out there?

Here’s a retailer who poured a whopping $ 150,000 of their savings into Tesla TSLA options:

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Business Insider

And then there is this guy. He put his entire IRA on options tied to technical stocks:

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Market observation

These options-grappling players are part of the tsunami of private investors that hit the market during Covid.

Wall Street always laughed at them for not having enough money to move the market. They were just brood compared to market whales like investment banks and pension funds, which own 80% of the stock market.

But it turned out that retail investors were tacitly using derivatives to “outinvest” Wall Street and became the rocket fuel that sent tech stocks to the moon. However, there may be a threat of withdrawal.

How options are brought to the point

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Options are contracts that you can trade on an exchange like any other stock. They come in two forms: calls and puts.

Calls give you the right to buy 100 shares at an agreed price by a specified date. When the stock goes up, you make money. Puts are the opposite. They allow you to sell the stock at an agreed price – and act as insurance if the stock falls.

The most important thing is that options give investors leverage.

For example, you can buy a call contract today for $ 400 that gives you the right to buy 100 shares of Apple AAPL for $ 112.5 through October 9th. That same $ 400 would buy you just under 4 shares of Apple.

In other words, options give you the ability to hold hundreds of stocks for just part of the cost of actually buying them. They also increase your returns (or losses).

For example, if Apple jumps to $ 122.5 by October 9, use your right to buy 100 shares of Apple for $ 112.5, which you then sell for $ 122.5. Take away the $ 400 reward and you’ve bagged $ 600 – a 150% profit.

Meanwhile, Apple stock would have given you an 8% gain in the same situation.

Retail investors are piling up in technical options like never before

Institutional investors who place large orders dominate the options market. But in 2020 swarms of return-hungry mom and pop merchants quietly knocked them over.

Take a look at the table below. As the market rebounded, retail investors began to take call options like there was no tomorrow:

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Call option trades

Meanwhile in the markets …

In August they bought 6 times more call options than a year ago. In just four weeks (from mid-August), they made a record $ 37 billion in calls, according to Sundial Capital Research

And to do that, individual investors have at one point made more than half of all option trades in the market – even “out-invested” Wall Street whales. (Remember: you usually control 80% of the stock market.)

I looked at what they bought. Here is a list of the stocks with the most active options (technology highlighted in yellow):

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Stocks with the most active options

Meanwhile in the markets …

No wonder 8 of the top 10 stocks are household tech darlings – including high-flyers Tesla (TSLA), Apple (AAPL), and Nikola (NKLA).

Now here’s the most interesting part.

How, on average, Joe’s became one of the dominant forces in the market

Retail investors buying $ 37 billion worth of call options in four weeks are a lot to themselves. But that’s a flyspeck compared to the gears that these contracts have turned in the machine of the market.

The Economist estimated the contracts were tied to approximately $ 500 billion worth of shares. And even if investors didn’t exercise a single contract, they forced the option seller to buy some of those stocks.

You see, options are sold by traders called market makers. They are large financial institutions whose job it is to buy and sell securities such as bonds, stocks, and options at all times. (In financial jargon: provide liquidity.)

If you want to sell a stock, they are there to buy it. If you want to buy a call option from Tesla, these are there to sell that contract to you.

The problem arises when, for example, you want to buy a call option but don’t have a seller for it. Then the market maker has to write the contract himself. If the buyer gets it right and inventory goes up, the dealer is hooked.

Look at the same Apple example. In this situation the market maker would have lost money. The deal would have forced it to buy 100 shares of Apple at $ 122.5 and sell them back to the option holder at $ 112.5.

In order to avoid the risk, the market maker buys the share as soon as he sells the call option (“delta hedging”). That is, when private investors poured a record $ 37 billion into options, moneymakers had to buy up to $ 500 billion worth of stocks. In four weeks.

Even a chunk of that is a huge pile of money – most of it ended up in technology stocks. From a perspective, private investors bought only a third of the net in 2019. This is what it looks like:

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Infographic: How options mania drives stocks

Meanwhile in the markets

Such money can even shake tech giants to historic highs.

What it all means for you

Tech had every reason to move up in 2020. Covid pressed the fast-forward button on many technology trends and increased the demand for internet services. But the option craze may have pushed the technical boom beyond any reason.

What if stocks wobble and kitchen table traders lose interest in them? What if money makers start selling hundreds of billions of dollars in hedged stocks?

I wouldn’t rule out another retreat. And that would affect everyone – even those who hadn’t got their hands on technology stocks.

As I wrote in Meanwhile in Markets … technology makes up about a third of the S&P 500. ETFs that track this index are among America’s most popular funds. They also belong to the pension investments.

Even a decline in technology could pull all of those funds down. And we recently got a taste of what that looks like.

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This is not investment advice.

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