As always in bubbles, speculative appetite has accelerated towards the apex of the bubble. Like moths to a flame...
Picture a scenario in which the broader market peaked almost a year and a half ago. Last year's 2019 Fed capitulation rally was propelled to new highs solely by Tech and recession trades. Now, in 2020 over HALF of S&P gains year to date were driven by an even smaller cadre of just five Tech stocks. And since the beginning of February, those stocks went further parabolic due to RECORD call option speculation.
Now you get a sense of what's coming...
At the height of the Y2K Tech bubble, just as now, many pundits said that value investing was dead. "Valuations don't matter" anymore. Adherence to that consensus view peaked and exploded at the same time as the bubble. Value investing indeed came back from 2000-2003 on a relative basis. However, the S&P 500 still lost -50%. In other words, when the most overvalued and overowned part of the indexed bubble explodes, it takes down the entire market. No rotation to underweighted left-for-dead cyclicals, can stop that from happening when overweighted growth stocks are collapsing.
Since the Trump Casino is closed today for Dictator's Day, I wanted to explain how the options market has taken over the casino. A massively leveraged casino within a massively overvalued casino. First a primer on the options market:
We all know that an option is merely a bet that a stock/index/ETF will rise or fall a certain amount in a given period of time. Most gamblers are familiar with what happens on the long side of the trade: You have a certain amount of time to be right or lose the entire premium/investment. Most have no idea what happens on the other side of the trade, which is why most options expire worthless. Especially short-term options. First off, there is no such thing as free money, so someone buying Tesla call options for example, is essentially renting capital. At an $800 share price, each contract (100 options) controls $80,000 of Tesla stock at the money, using a fraction of that amount of capital. The cost of capital is embedded in the option premium which factors in time to expiration aka. the rental period. Many gamblers have gravitated to the weekly options because they are the cheapest and hence most speculative. Essentially lottery tickets. What they don't understand is that the dynamics of the options market almost ensure they will lose money, especially on that short of timeframe in a crowded trade.
Why? Because as the trade becomes more crowded, the near the money call options skyrocket in cost (premium), forcing gamblers further out of the money to gain leverage. Meanwhile, the market makers on the other side of the trade are hedging their (short) Tesla option position by buying the underlying stock. So when there is a frenzy of out-of-the-money options buying, the stock is propelled upwards by the rented capital. However, as the stock price approaches the most heavily owned strike price, the hedging pressure reaches a plateau wherein the market makers are fully hedged 1:1. At which point momentum wanes and time decay takes over, as every elapsed minute means a lower probability of the stock closing above the most crowded strike price. Therefore market makers can start peeling off their hedge, putting downward pressure on the stock. This momentum reversal accelerates as the stock price leaves the strike price, as the probability of exercise becomes increasingly less likely. In other words, the feedback loop reverses.
Any questions?
Any questions?
All of which is why highs in the call/put ratio, precede large market moves lower. The massively leveraged momentum feedback reverses, and stock gets automatically dumped back on the market:
No surprise, gamblers have gravitated to the best performing stocks of the past year, to play this Corona melt-up. In other words, they looked around to find the most overvalued and overbought stocks and drove them higher on record call volume.
What could go wrong?
Of the top fifteen, Tesla is #1 of course with an 829% surge in options volume and $80 billion daily average value. Followed by Amazon with a 60% surge and $60 billion in daily value. Apple volume up 111% and $24 billion in average daily value. The two Googles combined, up 150% in volume at ~$17b in value. And Microsoft seeing a 300% increase in option volume and $9.6b in value.
Add in AMD, Nvidia, Netflix, IBM, and Facebook to round out Tech dominance on that list. Meaning that the majority of the Nasdaq's daily active dollar volume is now record leveraged to the options market.
"single stock options volumes are now 91% of shares, a 14-year high"
Which means that as these lottery tickets expire, record amounts of parabolic stock will automatically be dumped back into the market.
Meanwhile, hedge funds, having underperformed for a decade straight, have learned that they need to aggressively overweight Tech. Which is why they are overloaded on MAGA Tech:
The article is subscriber only, but we can see what's in this ETF, here:
It's 52% dominated by the MAGA Tech sectors. It has to be in order to outperform the market year-to-date:
Meanwhile, hedge funds, having underperformed for a decade straight, have learned that they need to aggressively overweight Tech. Which is why they are overloaded on MAGA Tech:
The article is subscriber only, but we can see what's in this ETF, here:
It's 52% dominated by the MAGA Tech sectors. It has to be in order to outperform the market year-to-date:
All of which is why the Tech sector is 20 year overbought (based on relative strength (RSI), top pane):
"Apple suppliers in Asia will be closely watched"
