The Big Explainer
What is the impact of options on the equity market?
This week Roger Hirst looks at how options activity can have a material impact on equity markets. The summer of 2020 saw a rise in single stock option volumes on companies such as Apple and Amazon, driven by a surge in retail volumes. This resulted in a great impact on the equity market and in this episode, Roger looks at the dynamics of how the prices within the equity markets were moved.
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[00:00:00] Welcome to The Big Explainer. One of the biggest stories over the summer of 2020 was the rise in single stock option volumes on, for instance, Apple and Amazon, driven by a surge in retail volumes and more importantly, the impact this had on the market. In this Big Explainer, we look at how options activity can have a material impact on equity markets. Now, I'm not going to do a deep dive into options trading, where it's easy to get bogged down by all the jargon such as the Greeks. I am going to look at the dynamics and how this can move prices within equity markets.
[00:00:47] First let's look at what all the fuss was about. The US equity market had been outperforming most other equity markets since the lows were made in March 2020. Within the US equity market, the mega cap tech stocks took the lead, taking both the Nasdaq and the S&P 500 to new all time highs, despite one of the fastest and deepest declines of economic activity ever seen. Now it became clear that retail investors were heavily involved in the rebound and that they were buying single stock options as well as the underlying stocks. During the summer months this options buying gathered momentum. And there were a number of extremely notable features. Firstly, the S&P Volatility Index, which is called the VIX, was rising while the S&P 500 was also making new highs. And that's fairly unusual. In early September, we actually saw the highest ever VIX level simultaneously recorded with a new all time high on the S&P 500. Now, prior to this period, the last time that we saw the VIX at similar levels when the S&P 500 was making new all time highs, was back in the dotcom bubble era of 2000. So here we need to make one of our first distinctions, which is between implied volatility and historical or realized volatility. The VIX is an index of implied volatility. This is based around what people are willing to pay for volatility products such as options. It's not the same as the actual volatility of the underlying index or equity. The actual volatility of the underlying instrument is the historical or realized volatility. Normally, the historical and implied volatility move around roughly in tandem. So if the S&P 500 had, for instance, an average historical volatility over the last month of twenty and a one month option on the S&P 500 could be bought or sold for an implied volatility that was also around 20, then the options price is deemed to be around fair value, although these numbers will be simplifications of reality. Now some people will talk about implied volatility, whilst others will talk about historical volatility. They're obviously related, but they're not the same. Now, what was of particular interest in early September of 2020 was that the implied volatility of the S&P 500, and that's what people are willing to pay for volatility products, it was going up and it reached 25. Whilst the comparable historical or actual volatility of the S&P 500 index was closer to 10. We could say that these options were expensive because one was a 25 sort of moving like this and the other was around 10 so a much, much lower volatility. So historical volatility is usually low when markets are grinding out new highs. And this is what we saw in 2017. There have of course, been some occasions when both underlying index and implied volatility rise together. We saw this in 2018, just before the event, now called Vol Mageddon occurred. And it's also frequently happened in Japan. When it also happened in the dotcom era however, the historical volatility was in the mid 20s at the same time that the levels of implied volatility of the VIX was at the same sort of level, again in the mid 20s. So unlike early September of 2020 people were paying roughly fair value for options back in that dotcom era. So now moving back to the summer of 2020, there were a number of reasons for the increase in implied volatility. Firstly, retail investors were overwhelmingly buying call options, which is the right to buy an underlying asset. And a put option is the right to sell. The FT quoted a Goldman Sachs calculation that the notional call buying in late August and early September of 2020 was over three times the rolling average from the 2017 to 2019 period. Other estimates suggest that the notional call buying in single stock options reached 140 percent of the underlying cash volume. This figure would have been closer to 40 percent three years ago. And research house Sentiment Trader noted that new call buying in terms of notional value soared to five times the level that was seen at the dotcom peak. They also used data from the Options Clearing Corporation to calculate that retail investors spent over 40 billion dollars in option premium alone during August. So here's some more terminology. What's the notional? The notional is the face value of the options contract. One stock option contract on US equities will usually give the purchaser the right to buy or sell 100 shares per option contract. So if a stock is trading at $50 the theoretical notional would be the $50 stock price x by 100 shares or 5000 notional per share. Now some people might like to delta adjus this number, but that's for another time. The premium is what you pay for the options contract. The premium on an option is like the premium on a home insurance contract. The notional value of the home insured is like the notional of the options contract. Another feature of the summer buying spree was that volumes were focused in just a handful of mega cap tech names like Apple and Amazon, but the size of each position was small. They were generally 50 contracts or less giving exposure to 5000 shares or less per transaction. It is very unlikely that this was institutional activity, though high frequency trading was probably involved. There was also another large player in size over the summer of twenty twenty, but I'm not going to focus on that here. They were covered in The Big Conversations published on the 9th and 15th of September 2020.
[00:06:21] So how did this activity drive up both the price of the underlying shares and the levels of implied volatility? Well first, the sheer size of the buying meant that there was strong demand for the underlying shares. So when someone buys a listed option, a market maker will probably sell it to them. And then they hedge this position to neutralize the risk of the underlying share price. And market maker Susquehanna noted that most of the options are bought by retail investors had less than two weeks left until expiry. So listed options contracts, they have what's called a specific expiry. So car insurance, for instance, might give the owner cover for one year and then the insurance contract expires. Listed options usually have one expiry date per month. In the US and Europe the main one is the third Friday of every month. The September 2020 expiry was on Friday the 18th. So retail investors would have been buying their positions in the two to three weeks prior to that date. As we shall see shortly, as the expiry approaches, it changes some of the dynamics of the option. And the retail investors were also buying out of the money contracts. So what was that? So if the stock is trading at eighty dollars, the one hundred dollar strike for a call option would be an out of the money strike. In this case, it's 25 percent out of the money because the strike is 20 dollars or 25 percent above the current stock price. We can think of the strike as the target price of the underlying share. Now, when a market maker sells that call to the investor, they will hedge the position by buying stock, but it won't be the full notional of the stock. So for instance, if one option gives the right to buy 100 shares of Stock X at one hundred dollars, the market maker who sells the call may initially need only to buy 10 shares to hedge the contract if the stock is currently still at eighty dollars. The amount of stock required to hedge the position is called the Delta, which is one of the Greeks. So at eighty dollars, the market maker only needs to buy 10 shares as a hedge. If the stock then rises to ninety dollars, the market maker may now need to own 25 shares as a hedge. That's an additional 15 shares. And again, these numbers are just an example they're not exact. But if the stock then rises to 100 dollars, the market maker will need to buy another 25 shares to get a total hedge of 50 shares. But as the stock moves up to and through the strike of the stock, the market maker needs to buy more and more stock at a faster and faster rate, creating upward pressure on the share price. Therefore, if there is already buying pressure on the underlying shares, the market maker will need to buy more and more shares at a faster and faster pace until the stock has been pushed through the strike. Eventually the market maker may become fully hedged with a long position of 100 shares versus a short position in the options contract. At this point, the upward pressure from the market makers hedge would end. But what goes up can also come down. This whole process can work in reverse, too. So as the stock falls, the market maker needs to sell stock, adding to the downward momentum. And this dynamic was at work in the middle of September 2020. This dynamic can also be accentuated as we close in on the expiry date. Now the change in the speed of hedging the underlying stock is the gamma, yet another Greek, and the gamma increases as we get closer to the expiry. Again we will not focus on the gamma itself, It's just the impact that it can have. So if we are two or three weeks away from expiry and we bought the 100 strike option of a stock that was trading at one hundred, and this is called the 'at the money option', so 100 stock 100 strike, then the delta required to hedge that position would be something like 50 shares, which is half the notional. Now, if we move forward to the day of expiry, the impact of the gamma can be seen more clearly. If the stock is at 100 or above, the market maker may need to deliver all 100 stocks to the buyer of the option. But if the stock is trading below 100, the market maker isn't required to deliver anything because the option is now deemed worthless. The market maker would need to be 100 percent hedged above 100 and zero percent hedged below 100 at expiry. And in an extreme scenario, the market maker could end up having to constantly buy and sell the full notional position if it moved up and down through the strike on expiry day. In reality, the market makers have a bit more control than that. They might pin the stock above the strike, so, for instance, they might pin it at 101, and then deliver the stock at expiry, managing their inventory after the expiry. This is usually more extreme at the quarterly expires in March, June, September and December, when the volumes are at their largest. And to give examples of that, the low after the December 2018 sell-off took place on the first trading day after the December expiry. The low of the Covid crisis took place on March 23rd 2020, the first trading day after the March expiry and actual volatility in the S&P 500 picked up during the run in to the September 2020 expiry, with the first trading day afterwards on the 21st of September also notable. Now it must be stressed that large option positions themselves don't define the direction of the market, but they can accentuate the moves that are already in motion. So in summary, the massive demand for call options meant that the market makers were having to buy stocks at a faster pace as the prices of many mega cap stocks marched higher, triggering more gamma's stops and building a crescendo of buying. This also pushed up the cost of implied volatility, even though the underlying index was only grinding out new highs with a very low level of historical volatility.
[00:12:06] Among this summer's options activity, there was also a large institutional player impacting prices, and there was a dynamic at play that meant the VIX was squeezing higher as it rode up a bump in volatility around the US November election. But these are not for this explainer. However, if the retail investors are here to stay, then options, dynamics and expiry events will continue to play a key part in the performance of market prices and volatility. In this explainer, we focused on the upside, but the dynamics can be equally dramatic on the downside. Options don't define the direction, but they can act as an accelerant.