Plenty of media commentary over the weekend has linked the wild swings in the prices of US equities – particularly those of “big tech” firms – last week to developments in options markets. So it is worth asking exactly what role these developments may have played, and taking a closer look at whether they can tell us anything about what comes next.
The argument goes that many individual investors – plus at least one major institution – have been buying lots of call options on big tech, plus a few other, stocks. Chart 1 shows how the trading volumes of call options on individual equities in the US have surged recently, to a far greater extent than those of put options. The surge is mainly due to tech firms.
This has been interpreted as demonstrating the extent of retail investors’ exuberance in particular about those firms’ prospects, since buying out-of-the-money calls is a way to gain upside exposure to share prices more cheaply than buying the shares outright. It may also have contributed to a feedback loop, as market makers who have sold calls hedged their exposure by buying the underlying stock. This mechanism may have helped exacerbate both the huge scale of the run-up in the prices of many tech firms over the past few months, and their sharp falls towards the end of last week.
Even if we see further bouts of volatility in the big tech stocks in the coming weeks, we would not interpret this as a sign that a major dotcom-style tech bubble is about to burst and drag the rest of the market down with it, for two key reasons.
First, a significant chunk of the outperformance of big tech firms has been driven by fundamentals. While options market shenanigans may have contributed a bit lately, the main catalyst for their rally is simply the fact that their businesses have done extremely well, in both absolute and relative terms, during the coronavirus crisis. That has not changed in the past week.
Second, in contrast to the dotcom era, investors are fairly downbeat about almost everything outside of big tech. One way of demonstrating this is via another, less heralded, development in options markets. When it comes to options on equity indices, rather than individual names, there has been no surge in call trading volumes. In fact, put volumes have been slightly higher. This suggests that investors’ primary concern has been protecting themselves against broad-based weakness, the opposite of the caution-to-the-wind behavior you might expect to see in a bubble.