Over the month of August, money managers throughout the world stood with mouth wide open as the tech heavy NASDAQ defied all manners of technical stock price movement and fundamental value concepts to reach record, after record, after record.
First, as we are discussing the stock market and its underpinnings, do not under any circumstance use this information as any advice whatsoever in any investment decision making. Make your own decision based on your own analysis.
This led to analysts trying to get ahead of each other and kept raising price targets. For example, for Apple it went from $400 to $450 to $550 a week back (Before Apple stock split).
Today, one piece of the jigsaw is finally solved. A ‘big whale’, or a trader which enters super large positions were behind this move and it was Softbank of Japan. Softbank had been spending billions to buy out of the money call options which stoked the rally.
How it works
A small primer on how buying huge amounts of call options could lead to a meltup. When a trader like Softbank lets say buys $100 million of call options on Apple, the trader makes money if the stock price goes up. But this is a strictly zero sum game, the gain made by Softbank will be at the expense of the bank who sold Softbank the call option. And options have this leverage like structure which can multiply returns if the idea is working (and lose if the idea does not).
To give a strictly hypothetical example*, lets say a trader buys $100 million of $120 call option on Apple expiring Dec 31, 2020 is worth $1.00 when Apple is trading at $100. As the stock price of Apple increases, lets say by 20%, to $120, the call option is not increase by 20%. It could increase to by 500% to 600% to be worth $6 to $7 and the trader makes $500 million. So options have this effect of leveraging returns when the idea works out (and losing if it does not).
Let’s call this Trade A. *All figures are hypothetical
But this gain of $500 million is a strictly zero sum game. If Softbank gained $500 million, then the bank which sold Softbank the options loses $500 million – this is known to the bank at the point at which they sold the options. In order to protect itself, the bank calculates a ratio called a “delta”, which ranges from 0 to 1. So lets say at $100 , this “delta” is 0.1, what it means is that for every 10 options the bank sold to Softbank, the bank will have to buy 10 x 0.1 (Delta ratio) = 1 share of Apple. So the price of Apple increases a little because of the new demand for Apple shares due entirely to the bank having to hedge their call option sold by purchasing stocks. This process is called “delta hedging.” The whole purpose of delta hedging is to reduce the risk to the the bank which sold this call option to the trader, or the whaler if you are Softbank. It works because the bank’s delta risk position also increases in value as the stock price increases, so net-net the bank is still ok.
But there is a catch, namely that this “delta ratio” keeps on changing as the stock price moves around. So long as the delta ratios don’t move by much, its ok, but sudden jerky price movements can change this.
Now, here is where things get interesting. Robinhood traders, basically Gen Z’ers who trade on the Robinhood platform , start to notice Apple going up a bit and start to buy shorter dated out of the money call options, which are cheaper and offer more leverage. The delta on these call options are very small, maybe 0.05, which the bank is happy to sell them and pockets the risk cost difference.
However, unbeknownst to everybody except Softbank, they actually have just started their game. The next week they increase another purchase of call options, again at a massive amount – $100 million. The stock price increases because of the necessity to hedge this purchase of call options, and the bank buys another amount of shares in the proportion of the “delta ratio”. However, there is now a catch – as the stock price continues to increase, the previous “delta ratios” on the earlier $100 million dollar investment increases as well, lets say from 0.1 to 0.4. So now the bank has to purchase additional 0.3 stocks of Apple for every call option sold in the earlier whale trade, Trade A. Even worse, they now also have to increase purchases of stocks for every call option sold to the Robinhood traders. The Robinhood traders, unaware of all of this, start posting on social media on how they are “making a killing” on the stock market.
In August alone, Tesla’s share price shot up 74 per cent, while Apple gained 21 per cent, Google’s parent Alphabet rose 10 per cent and Amazon 9 per cent. FT reported a source as saying the volume of call options sold for these tech darlings were the largest in the last 20 years.
Things get worse when the professional money managers get involved. This is because even though these folk may not engage in this option skulduggery, their fees are based on how much they outperform a particular benchmark, lets say the S&P 500. In this case, lets say a pension fund, call it Muppets Pension Fund gave $10 billion to Mr. Fund Manager with the mandate of outperforming the S&P 500.
For every percentage point Mr. Fund Manager outperforms the S&P 500, they get 20%. So Mr. Fund Manager is incentive to beat an index by making so called careful stock selections based on careful financial analysis.
But now, it seems that the only game in town is this artificial tech fueled buying bonanza spurred caused by Softbank, which is hidden to everyone. His clients keep pestering him, or he succumbs to pressure and decides to increase his holding of Apple stock because that will help him beat the market further.
These are the so called – institutional money managers, folk who can push up a stock massively if they all get lemming fever and decide to follow suit. The price continues to increase, again.
Now an even worse situation happens. Mr. Watanabe in Japan, Mr. Hans Wigglebottom in Germany and Mr. Magoo in the UK keep looking at the NASDAQ taking record after record due to this speculative cycle described above. Their investment profile is not suited for high risk technology stocks but they convince themselves that Apple trading at greater than 30X forward Price Earnings ratio makes sense and decide to plunge headlong. They feel happy as they see Apple gain 5% in 2 days – much more than they could make in 5 years in their 0% or negative interest rate scenario if you put the money in the bank. This is not a hypothetical statement – Japan’s massive Government Pension Fund actually buying of call options this summer.
The price keeps on increasing further, and further and further.
The point to note is that this is a positive feedback loop process. Feedback loops are notoriously unstable. From the Softbank Whaler’s single mega option trade, there are now other market participants who have plunged into extremely risky tech stocks. This investment strategy may not be suited to these investors risk tolerance and risk absorbing capability.
Explaining market talk
This, according to McElligott (and Citadel), “is why CRM had its freakish +26% post-EPS single-day move last week (lolwut), and dragged-up a number of other high-profile big name Tech which have also been part of the upside buying program (AMZN, ADBE, NFLX, FB, MSFT) all enormously “over-shooting” thereafter, as generically, the Street was short 1m 20d Calls which turned 25d real quick, forcing Dealers to grab Delta to stay hedged, in classic “tail wags the dog” feedback loop.“
The above is quoted from Citadel market strategist and cited in a Goldman Sachs report which was carried by Zerohedge.com, a financial doom and gloom predictor. What it is saying is that when CRM, a company which sells cloud software reported its earnings last week on Tuesday 26th August 2020 which the whalers (ab)used to trigger a massive price spike. The stock moved a massive 26%, basically about $60 to take the stock from $216 to $276 in a single day. This massive move also pulled up a lot of other big cap tech stocks because of a huge amount of call options on these big cap tech stocks triggered a “melt up” rally as the price increased. CRM closed on Friday 04th Sep 2020 at $255.
Fact Box : Coronavirus Rally is not the same as the Trump rally
So if you think about it, what you have is a “melt up” cycle that feeds on itself. The current Coronavirus tech rally was built on the back of higher volatility, which was very different from the earlier benign Trump rally in 2017, when stocks moved up almost everyday in a slow and sustained fashion.
This is evidenced by the higher volatility in the VIX chart. The thing to note is that the VIX is property of the prices of stock options, in the case the more pricier they are, the higher the VIX and the cost of the option.
A higher VIX implies that folk believe prices can bounce a lot between massive ranges, like what happened on Friday in the tech world.
A quote from the FT that deserves some explanation:
“One person familiar with SoftBank’s trades said it was “gobbling up” options on a scale that was even making some people within the organisation nervous. “People are caught with their pants down, massively short. This can continue. The whale is still hungry.”” – Financial Times quote
Why are bankers short? After all they did not short the market or did they ? Well, actually they implicitly did take a short position the moment they sold the call option – they are short Delta and they are short volatility, or Vega. Both keep on increasing, with Vega increasingly massively due to these rapid price changes. The bank loses money if any of these quantities increases, so the bank is short both the stock and the rate of price appreciation .
How this can blowup in a bank’s face is that the price movements are dramatic, or so called “jumps”, this causes them to buy a larger quantity of shares due to the increase in the delta and at higher prices due as well to stay hedged. Whichever bank which did the Softbank trade would suffer a lot of pain, unless their traders and Market Risk Managers were super skilled.
The A-ha moment happens when bank traders from different banks begin to compare notes and piece together what Softbank is doing. They understand that this is a fake rally caused by Softbank’s option activity. And then the smart money sells.
As the smart money sells, the banks which have been buying up all these stocks to hedge their call options start to sell. The price falls as everybody is selling. The professional Wolves of Wall Street, the hedge fund managers have smelt this as well. They now make huge put option purchases, betting the price will fall. The bankers are happy to sell them that but instead of buying shares as the price falls, they will need to sell shares as the price falls. All of this happens in a matter of hour.
This happened on Thursday, when the NASDAQ crashed an Apple, which had traded as high $137 fell to $120. On Friday, Apple traded as low as $110 before “recovering” to $120.
What changed on Friday is the above article from the Financial Times. You should read it by subscribing to them.
Folk have now figured out what caused the tech stocks to increase rapidly, due to Softbank acting as a whale. Usually when this happens, a bloodbath ensues.