How Large Options Trades Impact Markets
What is making the stock market move? Is it news of an ever-increasing supply chain issue? Is it the fact that there may or may not be enough natural gas to keep America warm through this coming winter? Is it all irrational? Is the random walk theory really applicable to today’s maniac markets? Do you really believe that Tesla rallied 12% on Oct. 25 due to Hertz announcing that it was interested in placing a large order of Tesla cars for their car rental fleet? What if I told you that $15 billion worth of call options premium flowed into Tesla stock that same day? What if I told you that on Sept. 30 of this year, the SP 500 index dropped 1.5% because a bank was rebalancing one of their options trades?
On Sept. 30, J.P. Morgan placed an options trade that caused financial markets to drop 1.5% that day. What is an option anyways? An option is a binding financial contract between a buyer and a seller. There are two types of options contracts: a call and a put. A buyer of a call option pays a premium to the seller to have the right, but not the obligation, to exercise their option to purchase 100 shares at the agreed stock price as long as the stock’s price is at, or higher than, the agreed price before or on the option’s expiration date. A buyer of a put option pays a premium to the seller to have the right, but not the obligation, to exercise their option to sell 100 shares at the agreed stock price as long as the stock’s price is at or below the agreed price before or on the option’s expiration date.
Options were created for institutions and individuals to insure their portfolio for a cost. In American public financial markets, there are market makers that insure and provide liquidity to the markets. They’re the ones taking the other side of your trades when you place them to insure and protect the stability of markets. Because these market makers are more interested in remaining neutral with their exposure to markets, they use various ways to hedge out these transactions through purchasing or selling stock based on their needs. If a big bank wants to hedge out risk through the purchase of put options, the market maker would have to sell (write) the option to the bank, collect the premium for selling the option and have to sell shares to hedge their risk.
Why does the market maker have to sell shares to hedge their risk? This is because the market maker is taking the opposite side of the bet. If the stock goes below the agreed-upon price, the buyer of the put option would be able to sell 100 shares per contract to the seller of that option. To hedge this downside risk, the market makers sell shares in proportion to how likely it is for the stock to reach or cross the agreed-upon price of the contract on or before the expiration date of the contract. This creates a delicate dance in the stock market because of a sudden extraordinary increase in demand for calls or puts that can cause an imbalance in the market makers’ models and in turn cause ripple effects throughout the market as the market makers hurry to hedge their new positions.
On Sept. 30, J.P. Morgan bought 45,000 SP 500 index put options expiring in December as part of their JHEQX hedged equity fund mandate. Because not everyone enjoys paying a hefty premium for hedging, the bank decided to simultaneously sell 45,000 SP 500 index call options. This enabled them to collect a premium for selling (writing) the call options and use the proceeds to pay for their put options. The market makers had to sell the bank the puts and buy the calls the bank wanted. Both of these trades required the market maker to sell a tremendous amount of shares to hedge this one transaction.
The exact amount of shares that were sold to hedge this trade are unknown; however, Sergei Perfiliev, previously a quantitative analyst at Goldman Sachs, estimated that every 1% up or down move in markets could cause the market makers to either buy or sell around $1 billion worth of shares. The interesting thing about this delicate constant hedging game is that the values used for hedging are all based on historical and expected future volatility in markets. The metric market makers use to hedge their options holdings is Delta. The delta of an option is how much an option rises in price based on a $1 move. The delta of an option is based on its vega, or how much an option goes up or down in price after a one-point change in the stock’s implied volatility.
It’s all tied to how volatile markets are. When the market makers began to sell this tremendous amount of shares to hedge their risk, it sent the indices lower, causing implied volatility to rise, which made the vega of the put options rise, which caused the delta of the options to rise, which caused the market makers to sell more shares to hedge this additional risk. This continuous cycle can be advanced further if other big players hedge the same way at the same time. This is something that we saw in markets as they crashed in March of 2020. However, if markets remain stable for long enough, implied volatility subdues. Additionally, if the options that the market maker was hedging against expire, then the market maker unwinds their hedge and causes markets to rally.
However, what if big players, otherwise referred to as whales, decided to buy short-dated options on individual stocks instead of long-dated options on indexes?
On Oct. 25, $15 billion worth of call options were bought in Tesla stock. The majority of these purchases were in short-dated options; options that were expiring on the 29th of October. This caused the market makers to have to sell the call options and buy shares to hedge their risk. Being short a call means that you are selling the right to someone else to buy 100 shares from you at the agreed price. If you do not own these shares, you are practically shorting shares at the agreed-upon price. The significance of the short duration aspect of the calls is that the market maker has to hedge more aggressively against their trade. Without getting into too much detail as to what gamma weaponization is, this unforeseen radical change in demand for Tesla calls caused the stock to rally to all-time highs.
Although some might view Tesla’s rally on Oct. 25 as a great thing, because after all, rallies in the stock market may bring about financial prosperity for some, I find this new trend extremely dangerous for the stability of financial markets. Everyone is celebrating when their shares rise in price, however, will they be celebrating when the options markets opt to buy short-dated puts instead of calls, thus causing their accumulated wealth to fall?
Photo Caption: Large participants in financial markets are often referred to as “whales.”
Photo Credit: Pixabay