Option Dealers Pushed Prices to Extremes in Day Trader Onslaught
Option Dealers Pushed Prices to Extremes in Day Trader Onslaught
(Bloomberg) -- Amid last month’s frenzy in options, some investors said they saw an age-old ritual playing out. Newbie traders, blinded by dreams of riches, rushed into the market, where Wall Street professionals sat waiting to take advantage of their enthusiasm by raising prices.
A few volatility analysts saw signs that dealers cashed in on novice buyers by pushing up options costs in the most popular stocks. By these accounts, individuals were so hungry for Apple Inc. and Tesla Inc. options in late August and early September that they were willing to buy at any cost.
“That’s the perfect scenario: you get this big wall of demand that doesn’t really know what they’re buying,” said Matt Thompson, who runs volatility strategies as director of research at Thompson Capital Management. “All they know is they want the call and they want it now. You can keep raising prices of those short-term options if the demand is sufficient.”
As with most things in markets, opinion varies. What one person sees as opportunism, another views as prudence. To the latter, boosting the price of bets on technology stocks is a decision any good dealer would make in a market when those stocks were rising 5% or 10% a day.
One thing’s for sure: options prices turned extreme. In late August, contracts on Apple were the highest in almost a decade as measured by the premium of one month at-the-money implied volatility over 20-day realized volatility.
For Apple and Tesla, dealers were able to charge more for calls than comparable puts in August. In normal times, the opposite is true, since bearish contracts are in greater demand for hedging. For Amazon.com Inc., call option prices increased significantly relative to puts.
“There’s no doubt market makers were just raising the vols and Robinhood buyers didn’t even understand how that impacted the price of the options,” said Kris Sidial, vice president of Ambrus Group, a New York-based volatility fund. “They were more fixated on owning something that could provide a point of leverage.”
Also beyond dispute is that volatility, a key determinant of an option’s price, was on the rise. Parabolic gains in technology companies had made sharp rallies look more likely, justifying higher options prices. The November election and withdrawal of economic stimulus added to an uncertain outlook.
Matt Zambito, founder of markets data provider SqueezeMetrics, says big runups in Apple options made sense next to the wild moves in the stock.
On Sept. 1, near Apple’s peak, implied volatility was forecasting moves of around 2% a day over the next month. Since then, the stock has moved more than 3% a day on average. “If anything then, implied volatility may have actually been too low,” he said.
Volatility expectations don’t explain the full move in options prices, according to Brent Kochuba, who runs the analytics service SpotGamma. His view is that dealers, facing a tidal wave of demand from retail buyers, raised prices to prevent themselves from being overwhelmed.
“Market makers are required to make a market, and so their best way to dissuade call buying is to jack up prices,” Kochuba said. “This made buying calls way too expensive to offer a positive expected return.”
He pointed to Tesla calls that wouldn’t make money unless the stock moved more than 15% in three days as an example of extreme pricing.
He also saw the impact first hand in his personal account. After buying Tesla puts, he realized he’d bet wrong as the stock rallied. But thanks to the dramatic surge in options prices, the wager became profitable.
“It made money when the stock went up,” he said. “Never ever seen that before.”
Retail option flows typically go to market makers such as Citadel Securities and Susquehanna International Group, which deploy state-of-the-art computers to crunch fair value by the millisecond, transact large volumes and skim pennies off each trade while making sure they are not left with unwanted exposures.
A lot goes into the formulas dealers use to price options, including an estimate of a stock’s volatility. The more a stock swings around, the more likely it is to reach the strike price. Other factors, including how long it is until the contract expires, coming dividends, and its distance to the strike price, also affect the cost.
For the Robinhood crowd that have made and lost fortunes, their bullish convictions are still going strong. Last week, small traders bought 6.4 million more calls than puts. That’s half the number compared with the week before, but still higher than anything in the last two decades before the summer mania, according to SentimenTrader.
Justin Ferhati, a 19-year-old trading with his own savings and $30,000 from his father, said he’s practicing for a career on Wall Street and plans to keep dabbling in options despite some bad bets recently.
He posted a video on Reddit titled “Bumpy staircase up with a straight elevator down.” It showed his Robinhood account balance plunging from around $84,000 in early September to $19,000 last week, accompanied by sunglasses and thumbs-up emojis.
“You’re only at a loss if you stop trading because you’ll never ever be able to make your money back,” Ferhati said by phone from New York, where he’s attending college classes online. “If you trade options, it’s like a casino.”
©2020 Bloomberg L.P.