Retail investors are driving up call option premiums to levels that suggest irrational exuberance. In this article we share our take on what is happening and why. We then point out some important questions and potential investing opportunities.
Options give owners the right but not the obligation to buy or sell a security. Practically speaking ... they give investors the ability to take leveraged bets in markets. Leverage is dangerous so options are risky. Selling options is extremely risky ... because selling options is like selling volatility/insurance, only well-run institutions can do this...retail investors usually can't have a portfolio with enough diversification to offset the unlimited downside risk from selling options. But before getting into that let's cover some basics.
Key terms you need to know include the strike price which is the price at which the option holder can execute the option up until its expiry date when the option ends. The premium is the amount paid for the option. The premium is highly sensitive to the implied volatility of the underlying which is the referenced security in the option contract. Note that the implied volatility can be higher or lower than the historical volatility, but is typically higher in order to entice sellers into the market.
The two most common options are calls and puts...
Call Options gives the owner the right to purchase the option's underlying stock at a specific predetermined price, known as the strike price, on or before a specific date, known as the expiration date. The owner of a call option makes a profit when the underlying stock increases in price.
Put Options gives the owner the right to sell the option's underlying stock at a specific price on or before a specific date. The owner of a put option makes a profit when the underlying stock decreases in price.
The break-even point is the price at which an investor's net profit will be zero.
Break-even price = Strike price + Premium
For example, suppose you pay $3 for a call option with a strike price of $100. In this case the break-even price is $100 + $3 = $103. If the price of the underlying, such as a stock, goes down then the option losses value. If held to maturity and the price is below $100 then the option buyers losses the $3 premium and the option expires worthless.
While the downside of the call option is limited, the option is unlimited. In this example, any underlying price at expiration above $100 results in the option having a positive payoff. Here is a formula:
Call payoff = (MAX (underlying price - strike price, 0) - premium
So if the price expires at $106 the formula reads ...
MAX ($106 - $100, 0) - $3
= $6 - $3
= $3 profit per share.
The last critical concept about options that you need to know is the Black-Scholes model. The Black-Scholes model is an option pricing model developed by Fisher Black, Robert Merton, and Myron Scholes in 1973 to price options. The model requires six assumptions to work:
The underlying stock does not pay a dividend and never will.
The option must be European-style.
Financial markets are efficient.
No commissions are charged on the trade.
Interest rates remain constant.
The underlying stock returns are lognormally distributed.
We won't get into the model itself here as it is beyond the scope of our post. Suffice to say that trading platforms often provide outputs from this model to help traders understand what is baked into option prices such as the implied volatility.
That's it for basics...now into what's been happening.
Spotgamma wrote an article on the rise in call option demand that we think every investor should read. The key excerpts are as follows...
"The 2020 markets have been remarkable for a myriad of reasons but for us there is nothing more remarkable than call option demand. This past week we highlighted huge call induced moves in AMZN & ZM, and this week we came across the data set featured below. This data measures “Customer” flow which is essentially retail and “buy side” trading."
"As you can see the premium being spent on single stock call options is heavily outpacing that of ETF’ and Index. There was an initial call buying acceleration into Feb ’20 which at the time was record call volumes. However, following the March market collapse single stock demand soared both to news highs and in relation to ETF & Index."
-- End excerpts --
Equity option buying has been rising rapidly through 2020. The growth started before the pandemic so it's not just a work-from-home phenomenon. One reason is the ease at which platforms like Robinhood have made option trading. Robinhood has gamified trading with things like firework animations when you make your first trade. They also don't have many of the restrictions that other platforms have to prevent more risky strategies like options trading. Growth at Robinhood was fast before the pandemic...then it exploded.
We searched around to see how far back this growth in call options extends. The chart below goes back to 1992. Clearly we have never seen anything like this kind of growth in call option buying.
We corroborated this growth with Piper Sandler who points out that equity option trading, which is the trading of individual stocks, is 50% above last year’s levels year to date on all the options platforms including NASDAQ, CBOE, and ICE. As noted in the earlier chart...option volumes on ETFs and indexes is higher than 2019, but not by much, and given the extremely high volatility in 2020 I see no reason to suspect that this is irrational.
What does seem irrational is the demand and premiums paid on call options. Call option volumes have tripled since the end of 2019, and premiums have moved up similarly. By comparison, put option volumes and premiums are up only about 40% which is a lot but again, given the unusually high volatility of 2020 this is not obviously irrational. Moreover, put options are essentially insurance on stocks falling...a risk that has plenty of natural demand.
One result of this phenomenal growth in call option demand is a decade plus record in the Put/Call Ratio. TradingView suggests that this chart "needs little commenting", but I beg to differ. They think that this implies risk complacency...a sign that stocks are about to crash. But...
...Investors have 50% more put options open in recent weeks then in 2019. On top of that the VIX is still 40% higher than the average over the past few years pre-2020 (below). The fall in the Put/Call Ratio (above) is therefore being driven down by the rise in call options not because of a lack of demand for protection.
Call option demand is also highly concentrated. As of early December 13, 2020...these are the largest notional call volumes relative to market capitalization trading in the USA. This is an improved measure compared to a simple call volume. What we really want to know is how much options exposure investors are taking relative to the size of the company. Apple shows up at the top of all the call volume stats because it's the biggest company in the world. But that doesn't make it a magnet for speculation. Investors have 30 times more options exposure to TSLA than the average company ... and 50% more than the next runner up "Fastly".
When we sold some Tesla stock just before the September selloff because we suspected what we have now shown above to be true. Tesla is at the center of the Call Option Bubble. But it's not the only one to be concerned about. Retail investors are addicted to large cap tech generally. The top ETF notional options volume relative to market cap is QQQ. Speculation on QQQ is more than 4 times the next runner up...XLE.
This metric focuses on total option volume not purely call option volume. We did this on purpose. Retail investors can speculate on rising stock prices using put options as well by simply setting protection. While call option premiums are clearly driven by mania...total option volumes on some stocks like Tesla broadly reflect rampant speculation and downright gambling.
Putting this all together ... it seems clear that we have a lot of speculators buying up call options at just about any price. Robinhood traders are largely not going to understand the Black-Scholes Model and what implied volatilities they are. The call option prices on stocks like Tesla and Apple are so high that there is no reasonable scenario in which these prices remain so elevated. That is why I call it a bubble.
But the bubble is concentrated in just a couple dozen stocks...
Put option markets seems reasonably priced for both ETFs and individual stocks. You also see more outstanding put options on broader ETFs like SPY then you see call options...reflecting the natural and healthy desire for investors to protect against downside risk. This leads me to another important conclusion...
Put/Call Ratio is not a sell signal.
Investors are not ignoring risks in the broader stock market. This is clearly evident from the larger than usual level of put options outstanding despite their elevated price. The VIX is still above 20...compared to a three year average of around 15. So long as investors are buying more insurance than usual at higher prices than usual I see no reason to conclude that investors are complacent...even though the Put/Call Ratio is at all time lows.
Important questions remain regarding the Call Option Bubble. We also see some potentially profitable trading opportunities. If you would like to know our answers and strategies please share your own at IntuitEcon@gmail.com or replying in twitter. Please use "Call Option Bubble" in the subject line. The questions are...
Will the growth in demand for Call Options continue after the lockdown?
Is the Call Option bubble creating systemic risks for the broader stock market?
One strategy involves taking advantage of the massive difference in premiums between single name equities and ETFs. Some ETFs carry material sizes of companies like Apple and Tesla. We are investigating ways to sell single name calls and buying ETF calls in amounts that offset the risk in the underlying. If the data presented in this post is accurate then it seems we should be able to profit from buying the cheaper premiums on the ETFs and selling the more expensive premiums on the single names.
We will share our second strategy with those that email thoughtful answers to the questions above and their own potential trading strategy.