Sep 24, 2020
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The Stock Market Hangs On Not What You’d Think

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The stock market selloff stocks GETTY IMAGES Have you seen what s taking place out there? Here s a trader who plowed a hefty $150 000 of his savings into Tesla TSLA -9. 8% options: Headline BUSINESS INSIDER And then there s this guy. He bet his entire IRA on options tied to tech stocks: Headline MARKETWATCH These gamblers dabbling with options are part of the tsunami of non-public investors who swept the market during Covid

 

Wall Street used to laugh them off because they didn t have enough cash to stir the market. They were mere fry compared to market whales like investment banks and pension funds—which own 80% of the stock market. But as it turns out small investors quietly exploited derivatives to outinvest Wall Street and became the rocket fuel that sent tech stocks to the moon

 

However a pullback might be looming. How options work in a nutshell PROMOTED UNICEF USA BRANDVOICE | Paid Program
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Why COVID-19 Is Hitting Black And Hispanic Children Especially Hard Options are contracts that you can trade on a stock exchange like any stock

 

They come in two forms: calls and puts. Calls give you the right to purchase 100 shares of stock at an agreed price until a undeniable date. When the stock rises you’re making money. Puts are the opposite. They let you sell the stock at an agreed price—and act as insurance if the stock falls

 

Essential here’s that options give investors leverage. To illustrate for $400 today you can buy a decision contract that promises a right to purchase 100 shares of Apple AAPL -3. 3% at $112. 5 until October 9. A similar $400 would buy you just shy of four shares of Apple. In other words options give you the power to carry hundreds of shares for just a slice of the cost it might take to actually buy them

 

They also magnify your returns (or losses). If Apple jumps to say $122. 5 by October 9 you employ your right to purchase 100 Apple shares at $112. 5—which then you sell at $122. 5. Remove the premium ($400) and you ve pocketed $600—a 150% gain. Meanwhile Apple shares would have handed you an 8% gain in a similar situation

 

Small investors are piling into tech options like never before Institutional investors installing large orders used to rule the options market. But in 2020 swarms of return-hungry mom and dad traders quietly threw them over. Look at the chart below. As the market rebounded small investors began snapping call options like there has been no tomorrow: Call option trades MEANWHILE IN MARKETS

 

In August they bought 6X more call options compared to a year ago. In only four weeks (starting mid-Aug) they forked over a record $37 billion on calls per Sundial Capital Research And get this at one point individual investors made more than 1/2 all options trades available in the market — outinvesting even Wall Street s whales

 

(Remember: they generally control 80% of the stock market. ) I ve looked into what they bought. Here s a catalogue of stocks with the main active options (tech highlighted in yellow): Stocks with the main active options MEANWHILE IN MARKETS. No surprise 8 out of the end 10 stocks are household tech darlings—including high-flyers Tesla (TSLA) Apple (AAPL) and Nikola (NKLA)

 

Now here comes the main interesting part. How average Joes became one of the market s dominant forces Small investors buying $37 billion worth of call options in four weeks is plenty by itself. But that s a flyspeck compared to the gears these contracts started turning inside the market s machine

 

The Economist estimated that the contracts were tied to about $500 billion worth of stock. And whether investors didn t exercise a single contract they forced the option seller to purchase some of that stock. You spot options are sold by dealers called market makers. They are big financial institutions whose job this is to purchase and sell securities like bonds stocks and options at all times

 

(In financial lingo: provide liquidity. ) On the way to sell a stock they are there to purchase it. On the way to buy a decision option on Tesla they re there to sell that contract to you. The difficulty arises when you like to purchase say a decision option but there s no seller for it

 

Then the market maker has to issue the contract itself. As such if the buyer gets it right and the stock goes up the dealer is at the hook. Consider a similar Apple example. In that situation the market maker would have lost money. The contract would have forced it to purchase 100 Apple shares at $122

 

5 and sell them back to the option holder at $112. 5. To dodge the risk the market maker buys the stock as soon as it sells the call option ( delta hedging ). Meaning when private investors put a record $37 billion into options money makers were forced to buy up to $500 billion worth of stocks

 

In four weeks. Even a slice of that’s a humongous pile of money—most of which ended up in tech stocks. For perspective private investors bought just one-third as much net in all of 2019. Here s what that looks like: Infographic: how options mania propels stocks MEANWHILE IN MARKETS Such money can stir up tech giants even at historic highs

 

What this all means for you Tech had every reason to head up in 2020. Covid pressed the fast-forward button on many tech trends and puffed up demand for internet services. But the options craze may have driven the tech rebound beyond any reason. What will happen when stocks wobble and kitchen table traders become bored in them? And when money makers start selling hundreds of billions of bucks in hedged stock? I wouldn t rule out another pullback

 

And that could affect everyone—even people who hadn t laid their hands on tech stocks. As I wrote in Meanwhile in Markets. tech makes up about one-third of the S&P 500. ETFs tracking this index are some of America s optimal funds. They are also one in all go-to retirement investments

 

Even a dip in tech could drag all those funds down. And we recently got the taste of what that looks like. Stay ahead with big picture insights you won t find elsewhere A week I put out a story that explains what s driving the markets. Subscribe here to get my analysis and stock picks on your inbox

 

This isn’t investment advice

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