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Jan. 30, 2021, 12:14 p.m. EST

How an options-trading frenzy is lifting stocks and stirring fears of a market bubble

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By William Watts

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The Deutsche Bank analysts said that call volume is “largely responsible for elevated equity multiples” because institutional investors of all stripes have been “chasing since March.”

Feedback loops

Sharp gains in thinly traded stocks aren’t due solely to short covering, either.

Market makers that sell the call options to individual investors are left short the market. To bring their positions back to neutral, they buy the underlying stocks. Broadly speaking, if the stock continues to rise, the market makers must buy more to maintain their hedge.

An overall surge in online trading has been attributed to a number of factors, including cooped-up investors looking for ways to spend their stimulus checks last spring.

Of course, not all retail options investors are looking to force a short covering rally.

“What is often lost in the narrative is that retail investors have to manage capital really well,” said J.J. Kinahan, chief market strategist at brokerageTD Ameritrade.

For many options-trading clients, the instruments are a substitute for expensive tech stocks, he said. Buying a call allows the trader to clearly define risk since they’re only out the premium they pay for the option if the stock fails to rally.

Also, while the pickup in call buying has attracted attention, the “primary strategy” used by most retail options traders centers on covered calls, Kinahan said — a strategy in which an investor sells call options, garnering an income stream from the premiums, while holding the underlying security in an equivalent amount.

Fundamental disconnect

Hedge funds and other investors left bruised by short squeezes might not get a lot of public sympathy, though the Reddit phenomenon has raised legal questions around coordinated activity. The bigger concern among some market veterans is the disconnect between price action and market fundamentals.

Check out: Is GameStop’s wild ride due to market manipulation by social-media users — or are they exercising free speech?

The surge in call volume comes alongside other signs of froth, including low levels of overall short interest and high margin levels, said Tom Martin, senior portfolio manager with Globalt Investments, in an interview.

And when prices are being moved more by blind trading flows than new information, fundamentally focused investors face heightened challenges, Martin said.

Indeed, while the ability of individual investors to effectively “hunt” short sellers is a wrinkle that wasn’t enjoyed by dot-com-era day traders, it’s another reason for investors to worry that the broad equity-market rally is entering a dangerous phase, Zigmont said.

Instead, trading in certain stocks has become more about muscle, pitting individual investors against hedge funds and institutional players.

“It strikes me as dangerous, because at some point [individual investors] are not going to win the battle,” he said. It isn’t difficult to imagine a scenario in which individual investors fail to force a short seller to capitulate, eventually running out of buyers and leading to an implosion that could have ripple effects.

“Call buying on its own is unbelievable, but it’s also dwarfing put buying at the moment too,” wrote technical analyst Andrew Adams of Saut Strategy, in a note last week.

“It hasn’t mattered yet, but I am very afraid of what could happen if it ever does start to matter. Leverage and falling prices is never a good combination.”

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