Option Buying: The New Momentum Strategy Pushing Stocks Higher

Tuesday, September 15, 2020 6:43 AM | Neal Farmer

Investors are trading options and fast-rising stocks like never before. Often called "momentum trading", this strategy of buying stocks that are going up can be very profitable in a fast-rising market.

Buying options on those same stocks can lead to even bigger returns, with a lower outlay of capital, and we've seen increases in options trading from investors large and small recently as well.

While profitable, this kind of trading can increase volatility across the market, and when it comes to options, create a different set of distortions in prices.

Go Big or Go Home

Tesla (TSLA) is a great example of this trend. The stock is up more than 450% the past six months. The stock's initial recovery from the coronavirus lows was solid, but it wasn't until late June when its stock price really began to explode. And it isn't just the stock price, volume in options on TSLA also exploded, peaking around the time of Tesla's stock split.

Option Contracts Effect on the Market

Options are a great way to leverage a small amount of money into a big gain, by allowing investors to bet on lots of 100 shares for a price much lower than the actual share price. Because of the leverage involved, options can provide huge returns, but can also generate big losses.

Options don't trade in a vacuum though. In the same way that a herd of people rushing to buy a stock can send the price higher, a big increase in option buying will also have effects on the market.

One effect, since most options trades are facilitated by investment banks, and those banks don't want to carry the exposure of having sold a lot of options, is that the banks hedge those positions. The easiest hedge for sold options positions is to buy the stock, which helps exert more upward pressure on the share price.

It isn't a coincidence that trading in TSLA options saw a massive surge at the same time the price was rising.

And it isn't just TSLA, single-stock options trading volume recently passed the volume of trading in shares volume for the first time. Before the market crashed in February the ratio of single-stock options to regular shares volume was  around 0.8 which at the time was also a new high. After crashing to 0.39 during the crash, it shot upwards to where it is today at 1.23. This new love for options trading is being dominated by the trending stocks such as Tesla and Hertz (HTZ), but also big-tech stocks like Apple (AAPL), Microsoft (MSFT), Google (GOOG), and Facebook (FB) .

[caption id="" align="alignnone" width="519"]Single Stock Options Volume Record Levels, Goldman Sachs Single Stock Options Volume Record Levels, Goldman Sachs[/caption]

Market Movers

It isn't just individual investors making these trades. SoftBank (SFTBF) was recently revealed to be behind a $4 billion options bet helped stoke the tech rally. SoftBank's Vision Fund, the world’s largest tech-focused venture capital fund, was already heavily invested in big tech, so piling options contracts of top helped goose returns even further.

This volume of options trading just just effect the stock price. It also makes the options more expensive. The volume of call buying has been high enough that it actually cost more to buy calls than to buy a similar put, which is the options contract that pays off if a stock falls. Puts are usually more expensive, because of the upward bias of the market, so if calls are getting more expensive, it means banks are demanding high premiums for facilitating these trades.

What This Mean For You

As an individual investor, this kind of action in the market can lead to higher volatility. The adding, or unwinding of huge derivative positions can cause a lot of unusual things in the market. Those high-priced calls are likely part of the reason the Volatility Index (VIX) has remained elevated, and even risen, in periods when the market was rising, and as we saw last week, retreated when the market was falling.

It can also create some opportunities for investors interested in alternative options strategies. You can participate in the option selling. Covered calls, where an investor buys a stock and then sells call options against those shares can take advantage of those elevated call prices. This strategy can add some stability to your portfolio, while also allow you to purchase shares at a discount to the current price.

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