Are Options Impacting the Value of Stock Shares?

In this week’s issue of the Market Slice, we ask big questions like “Are options impacting the value of stock share?” and more to delve into what controls the world of trading.

Options Trades Driving Stock Prices?
The retail trading boom of the past few years has contributed to the current stock market bubble in several important ways.

For one thing, as we have pointed out repeatedly, there is the influx of wealth contributed by new market participants. Fueled by unprecedented government giveaways, millions of first-time investors have thrown billions of dollars into the markets.

While there has been a lot of added volume in stock trading, these days much of the excitement is in the options markets, which offer a low-cost, leveraged way for traders to bet on stock prices going up… without having to purchase the shares.

According to CBOE Global Markets data, the value of stock options traded now exceeds that of shares.

And while institutional traders still make up the majority of the options trade, much of this recent volume spike in options is from the retail sector.

Since an options contract gives the trader the ability to control 100 shares of a stock with far less capital commitment than it would take to actually buy (or sell) the shares, small account traders are tying up much larger blocks of those stocks than they could otherwise.

The result is greater volume in the underlying equity, as options writers (the traders selling the options) buy shares to cover the options they are selling… otherwise they would be “naked,” that is, committed to delivering a stock they do not own if the option is exercised.This could lead to massive losses, so most options writers prefer to be covered.

While some research has found that options activity doesn’t necessarily lead stock prices higher, other analysts suggest that conventional stock market wisdom does not adequately explain the new realities. 

With such a huge volume of options in play, the incentives to institutional players to buy or sell stocks as a way of “gaming” the options market is very real. And conversely, as we saw with the Reddit GameStop short squeeze, institutional “shorts” can also be punished by massive long options buying.

In effect, this kind of manipulation puts us in the highly unusual position of having options activity impacting share prices. This is a classic case of the cart pulling the horse.

As is always the case, when the rug is pulled and the inflated values in today’s market come crashing down, it will be the retail speculators that get hurt the worst.

Ultimately, stock market valuations are a function of interest rates, money supply, and fundamental economic factors. Options may be buoying equities for now, but when the reckoning comes, traders who went all-in with leveraged bets on a never-ending bull market will be left holding the bag.

Are you looking for the best ways to hedge your risks on the downside, while profiting from the late-stage bull market? Call FFR Trading today at (800) 883-0524 and speak with a member of our Strategy Team. We will give you a no-risk portfolio evaluation, and recommendations for trading strategies that suit your individual situation.

Pricing Options
In recent weeks we have looked at volatility, and how the wild ups and downs in stock prices have created opportunities for trading volatility indexes like the VIX. The other side of volatility, though, is the increases in options premium it creates.

Some traders have a hard time grasping the effect of volatility on option prices. This pricing mechanism relies on statistical (sometimes called historical) volatility, or SV for short, which looks at past price movements of the stock over a given period. 

Since options traders are speculating on future volatility, pricing can only be based on historical volatility combined with best guesses about what will happen to underlying prices during the term of the option.

A measure called implied volatility (IV) allows traders to determine what they think future volatility is likely to be. When times are uncertain and volatility is high, the cost of options goes up. 

Traders use IV to gauge if options are cheap or expensive. When we say that premium levels are high or that premium levels are low, what we mean is that the current IV is high or low. 

Professional option traders prefer to buy options when implied volatility is low, and sell options when they are high. Retail traders, however, often purchase a call or a put for directional trading, in which they expect a stock to move in one direction. 

This is the kind of leveraged trading we mentioned in the previous article… these traders may choose an option rather than the underlying stock due to limited risk, high reward potential, and less capital required to control the same number of shares.

The problem with this approach is that the high premiums necessitated by high volatility means that a big price move is required to establish a profitable position. Unfortunately, traders can lose a lot of money buying options, even when they are right about the price direction, either because the move doesn’t cover enough ground to recover the cost of the premium, or because it takes too long to get there.

Traders looking for an edge in the options markets want to make sure that they are taking advantage of leading-edge strategies, to offset the high cost of option volatility. Call FFR Trading at (800) 883-0524 to speak with a Strategist about your portfolio construction and trading goals. Or click here to schedule a time for your no-risk consultation.

The Ego Trap
The biggest problem traders face when evaluating trading ideas is our need to be right. It’s natural to want the validation that comes with saying “I knew it!” Especially when there’s money on the line.

There’s nothing wrong with wanting to win when we trade… after all, that’s the whole idea. But when our desire to be right starts to interfere with an objective view of our trades, we can get into trouble.

Ego attachment makes us emotional, and leads to poor decisions.

On the other hand, part of having a healthy ego is being able to admit when we are wrong, and make the necessary adjustments. Investors who treat their trading like a business and work from a plan, improve their success odds dramatically. With a businesslike approach, you can acknowledge your mistakes and move on without self-recrimination.

You understand that losing trades are inevitable, and missing on one trade, or even several, does not mean you are stupid, or even wrong. It just means the market didn’t go your way this time. It happens.

Let go of your need to be right, and allow the market’s feedback to correct your course. Manage your risk and cut your losses.

FFR Trading provides mindset guidance, as well as strategy design ideas. When you work with our Strategy Team, you always have someone in your corner to help you analyze your results and avoid the emotional pitfalls that can sink your account. Call (800) 883-0524 today to speak with a Strategist!

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