Are investors going too fast?
Analysts fear options trading frenzy could be fueling the next stock market bubble
The stock market is near record highs, and optimism abounds. Coronavirus vaccines are finally getting jabbed into arms. Interest rates are at historic lows. And the Democrats who control Washington are expected to pour another trillion dollars or so into the still-struggling economy.
But it’s getting increasingly difficult to overlook signs that investors are taking things too far, too fast.
The latest signal is from the somewhat obscure market for stock options, where traders can place bets with brokers that a stock will rise or fall. Speculation has reached a frenzied level not seen since the tail end of the dot-com boom two decades ago. That enthusiasm is having a growing influence over the regular stock market itself.
“If you’re betting on sports, the amount of people on one side of the bet or another can only influence the odds, not the outcome,” said Steve Sosnick, chief strategist at Interactive Brokers in Greenwich, Connecticut, a major options brokerage. “In the case of options, it can actually change the outcome.”
Over the past year, and even during the deep uncertainty that flummoxed the market at the start of the pandemic, individual investors — often with little experience — have been pouring into the market. What has lured them varies: free trades, extra cash from relief payments or even an itch for action with most sports leagues shut down.
Much of this money has come from small-time traders hoping to make fast gains by buying “calls” — bets on rising markets — set to expire quickly.
How can options drive the market? An individual who wants to make a bet that a stock price is going to rise can buy a call option at a brokerage firm. This contract gives the buyer the right — but not the obligation — to buy a stock at a given price at some point in the future. If the share price is higher on that date, the buyer can purchase the shares using the contract, then sell them for a profit.
But just as the buyer stands to benefit from a rising share price, the dealer who sold the contract stands to lose.
Brokerage firms make money by charging fees on products, not by predicting where share prices go. So to hedge their risk on a given contract, they buy a calculated percentage of the stock they would be forced to sell if the buyer ends up making money on the bet.
But as the stock prices rise, brokers must buy more shares to keep their hedges in balance. And buying more shares helps push share prices up.
In other words, rising share prices boost demand for shares even further, all because of market dynamics — not because of a fundamental view that the company’s business prospects are improving.
Will the market correct for the rise in prices?
The overwhelming optimism of stock options investors — and the chance that they are fueling a feedback loop of ever-escalating stock prices — is one of the reasons some analysts are concerned that a bubble might be building in the market.
If history is any guide, such bubbles tend not to last.
The frenzy back in 2000 was followed by a roughly 2 ½-year downturn as the stock market plunged 40%.