Every generation has its bubble, and this time it is about options, Ed Harrison told Real Vision during today’s Daily Briefing.
Harrison discussed the phenomenon of small traders buying bullish call options, a trend that was on the rise before the pandemic and is now being amplified by it. Options are an attractive instrument to investors because they offer non-recourse leverage; you can control a larger notional position with a smaller premium. When interest rates are extremely low, the cost of carry on these options is much lower, which is undoubtedly driving retail investor enthusiasm.
Harrison said that this mania is having unforeseen consequences because individuals aren’t taking offsetting positions; there’s a broker dealer in the middle and they have to hedge that position. He explained that a market-maker doesn’t want to take a position, they just give you flow, and when they give that flow and the price moves, it’s a big move in terms of the delta hedging they have to undertake because these are very short-dated options.
“They are effectively short the stock and they have to go and buy, so a large move in the underlying price means you get a large delta hedging effect, and that amplifies the move tremendously,” he said.
Harrison warned that a retail investor can miss this complication completely and therefore is at risk of being blindsided.
Harrison also discussed his longer-term outlook regarding this bubble and for the financial economy and urged optimists to be cautious. He said maybe this time will be different, maybe we can close the gap by the market trading sideways for 10 years or so while things catch up, maybe we won’t see a sharp correction and a bear market—but he thinks there is still another shoe to drop.
You have to leave the possibility [there won’t be a bear market] open because of the kind of activity we’re seeing, he said, but he will be watching the real economy and leaning on historical precedent for insight into how things may play out in the future.
Harrison said that weakness in the real economy tends to induce weakness in share prices, so he’s paying attention to earnings and the economy.
“We can’t have multiple expansion even when earnings and the economy are down,” he said. “That’s what the catalyst will be; historical precedent says that manias don’t end well.”
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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