Via Wolf Street

If stocks made a sudden connection to the worst economy in a lifetime, after having been disconnected for months, that would be a disaster, however.  

By Wolf Richter for WOLF STREET.

If you’re invested in Apple, Tesla, or many other stocks for which not even the sky was the limit, it has been a little rough over the past few days. But don’t worry, a new meme is circulating on Wall Street of why this time, it’s different – of why this time, there is a geeky reason for the selloff, having to do with call options, and with Robinhood traders needing to get wiped out. And after this process is over, since this was the only reason stocks swooned in the first place, their ascend can continue.

Much worse, so the meme goes, would be if the markets are suddenly reacting to the worst economy in a lifetime running on fumes of stimulus, or to the worst unemployment crisis in a lifetime, or to corporate revenues and earnings getting hammered, or to all simultaneously. Stocks reacting to and reflecting reality would be the worst-case scenario. But that’s not happening, the meme goes; it’s just a technical issue that will go away.

The “Heard on the Street” column in the Wall Street Journal summarizes up this meme, that “this type of selloff” – due to these call options undercurrents and Robinhood traders getting wiped out with their call options – “could be good news for tech stocks.”

It explains: “Unsophisticated investors getting burned with complex instruments are a less worrying cause for the rout than a change in the firms’ earnings prospects.”

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So here we go for the fun of it, descending a few inches deep into options geekdom and why the Robinhood options traders are now considered the sacrificial lambs that, after they’re sacrificed, will allow all these still ludicrously overvalued tech stocks to rise again during the worst economy in a lifetime.

This theory is based on the huge jump in options trading, and particularly of call options linked to the biggest names that are on everyone’s lips.

Buyers of call options gain the right, but not the obligation, to buy the underlying shares at a predetermined strike price by a predetermined expiration date. If the option is exercised, the writer (seller) of a call option is obligated to sell the underlying shares at the predetermined price to the option buyer.

This is a risk for the writer of call options, and the writer is paid to take on that risk via the premium. These writers are financial institutions, banks, and the like. Writing call options provides an income stream for them. But to hedge against that risk, writers buy the underlying shares when they write the call option – and that’s the feedback loop between call options and underlying stocks and their prices.

So far, so good. If option volume isn’t huge, and if the volumes of call options and put options (which serve the opposite function) are not too far apart, there is not a huge impact on the overall market.

But that hasn’t been the case recently. Equity option trading has been huge in recent months, and heavily skewed toward call options: According to Cboe data cited by the WSJ, call options volume has soared 68% this year, compared to a 32% increase in put options, and the gap between the two is now the widest since 2010.

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“Individual investors have entered this complex market lured by brokerages, which make more money on derivatives trades,” says the Heard on the Street column. “This year, retail trading app Robinhood has been a particularly popular entry point for amateurs investing their federal-stimulus checks. Earlier in 2020, this trend appeared to drive several market moves.”

So, the meme goes, Robinhood traders flush with stimulus money, or whatever, were plowing into call options to benefit from this market’s supernatural rally in the middle of the worst economic crisis in a lifetime. In turn, financial institutions which were selling these large volumes of call options were buying large volumes of the underlying shares to hedge against the risk. And this feedback loop has contributed to the rally in share prices while it was still going on.

But the meme goes, as the “Heard on the Street” column puts it, this type of rally “can unravel quickly at the first sign of trouble.”

Unravel, check. So now what?

Blowing out those Robinhood call-options traders and wiping out their accounts will reset the rally of sorts, the meme goes. Once that wipeout of those folks – for Wall Street, is there even a more maligned group of people out there? – is out of the way, the rally in tech stocks can continue. Hence, as the Heard on the Street column concludes, that “this type of selloff could be good news for tech stocks.”

Any theory – even one based on wiping out these sacrificial lambs trading at Robinhood – is better than seeing the absurdity of having had the biggest stock market rally leading to record stock prices during the worst economic crisis in a lifetime.

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