The Options Market

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In this section we will discuss the option market in more details. We will try to understand how and why this market has changed so much since 2008. Let's start by looking at the increasing volumes of short dated options. But what are they? Short dated options are options with a short term maturity, usually less than three months.

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Many investors also use daily or weekly ones to obtain larger profits. Short dated options are riskier than those with longer expirations. They offer higher returns but can also go to zero very quickly due to the theta effect. If the option does not become in the money having a limited duration, their intrinsic value tends to decrease rapidly as expiration approaches. Short dated options are often used by institutions looking to hedge short term risk or want to speculate on short term price movements.

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But why have the volumes of these options increased so much in the last 10 years and especially after COVID 19? Lets see what happened since 2008. In 2008, during the financial crisis and credit crunch, the Federal Reserve and other central banks around the world stepped in to support the financial system. They did this by first lowering interest rates and then by implementing the quantitative easing policy. This monetary policy has brought a large amount of liquidity into the markets.

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Under this regime, both stocks and bonds increased in value while interest rates were locked near zero. When the Fed fund rate is 0, corporate valuation can skyrocket. The discounted cash flow model teaches us there was too much liquidity in the system. The price discovery of financial assets was lost and companies were no longer priced based on their intrinsic value. The value of the assets went up because the cash had to be invested somewhere regardless of the price.

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When risk free assets such as government bonds have a near zero yield, liquidity has to chase positive returns elsewhere. This has brought big money into riskier assets, for example equities, even when valuation didn't support it. This situation has given birth to two concepts that have dominated the financial system in the last decade and which have brought us to where we are today. The first is moral hazard. This is an economic concept that refers to the risk that a person who has taken a risk will behave differently than he would if he had not taken the risk at all.

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Moral hazard can occur when a person or a company is protected from a loss by insurance or other type of protection. In this case, the individual may have incentives to behave more risky as they will not face the negative consequences of their actions. Moral hazard can be negative for financial markets as it can create price distortion and increase the risk of default. These monetary policies have prompted institutional investors to issue leverage and push risk to the limit. This moral hazard happened thanks to the Fed Put.

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But what is that? The Fed put is an investment strategy that relies on the perception that the Federal Reserve will step in to protect the stock market in the event of a significant decline. It is based on the belief that the Federal Reserve will do everything in its power to avoid a stock market crash by purchasing assets or releasing cash. Investors following the Fed Put strategy can invest in stocks or other instruments that they believe could benefit from the Federal Reserve intervention. These two concepts have led to a huge increase in speculation by institutional investors.

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This situation got worse post COVID 19 for the following reasons. During COVID the Federal Reserve has increased liquidity beyond expectations. This time it has not only supported the financial market, but with the help of government and tax policies, it has sent checks directly to citizens. This injection of liquidity has led assets to one of the greatest increases in history, to the point that the phrase stock only go up was born. Social media has then accentuated this growth.

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Influencers who have never invested have begun to encourage their followers to invest in a naive and dangerous way, using short, dated options. Federal Reserve policies that have been expansionary for too long have incentivized this type of behavior. Investors took more risk on what we called moral hazard because they benefit from the Fed put. We will go into specific cases later, but in the meantime, as we saw from the first slide, option volumes have more than tripled in just a few years, and this has made the financial system riskier due to an excessive increase in leverage. Now let's look at how options impact the markets and the activity of market makers.

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As we know, options use leverage. Leverage allows investors to buy assets with less cash than what they would require if they were to buy assets entirely with their own funds. For example, if an investor uses leverage to buy shares of $100,000 using only 20,000 of his own funds and 80,000 of loans, the leverage would be 4x or 100,000 divided by 20,000. So while leverage can increase potential investment returns, it can also increase risks as investors are exposed to greater losses if the price falls. As we said before, a decade of expansionary monetary and fiscal policies has led to a very high level of leverage.

[00:04:59.29] - Speaker 1
This leverage in the market has increased, especially with the growth of volumes in products such as options. During the course, we will talk in detail about market makers and their role in the financial system. But generally speaking, when an investor enters the market, there must be a market maker on the other side who offers liquidity and stability. However, the excessive increase in volumes and financial leverage also puts the market maker at risk because having an opposite exposure, he has the risk that the market could go against him. To avoid this, the market maker must hedge using a strategy known as delta hedging.

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We will talk about this in more detail in the next lessons, but what you need to know for now is that the market maker activity tends to move market liquidity throughout the day. Having a tool that helps us understand how market makers are positioning can be very helpful for investors. For this reason we have developed the Q models of Mentor Q. There will be a dedicated lesson to these models. We are looking to follow the activity of market makers to allow us to predict possible upward and downward movements and identify price areas on which to build our strategy.

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But let's go step by step so that we cover everything in the simplest way. Let's start with an introduction to delta hedging. First, we must talk about the moneyness of options. Option moneyness refers to the relationship between the strike of an option and the current price of the underlying asset. It helps classify options into different categories based on their intrinsic value and potential profitability.

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There are three primary classifications of option moneyness in the MONEY or itm, at the MONEY or ATM and out of the MONEY or otm. These categories varies if we are looking at call or put options. If we look at call options, we have three types of moneyness. If the strike of a call option is lower than the spot price of the underlying, the option is in the MONEY or itm. If the strike price of a call option equals the spot price of the underlying, the option is at the MONEY or atm.

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If the strike price of a call option is higher than the spot price of the underlying asset, the option is out of the MONEY or otm. The strike price is far from the current price and this is not positive for the buyer as the option has no intrinsic value. For put options, the moneyness is opposite. If the strike price of a put option is higher than the spot price of the underlying, the option is in the MONEY or itm. If the strike price of a put option equals the spot price of the underlying, the option is at the MONEY or atm.

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If the strike price of a put option is lower than the spot price of the underlying, the option is out of the MONEY or otm. Moneyness is an important factor in option trading as it can affect intrinsic value and time value. In this slide we can see how the Greeks of an option move according to the moneyness. We can see how the two Greeks, Delta and Gamma, move as the Option goes from out of the money on the left to in the money on the right at the money is in the center and it is also where delta and gamma are higher on the x axis we see the value of delta which grows the more the option goes into the money. At the money option have a delta of 50.

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The delta represents the probability at expiry that the option ends up in the money. The gamma instead represents the speed of the movement of the delta. Delta moves fast as it gets closer to at the money and so does gamma. We see the peak of the gamma when we arrive at the money. The closer the price gets to in the money, the more the gamma decreases because the delta at this point moves in the same direction of the underlying.

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But why are these profiles important? Every time we buy a call or put option, there is a market maker on the other side. The role of the market maker is to offer liquidity to the market and earn a spread for each trade. His role is not to take a position. Therefore he always wants his book to be market neutral.

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The market maker does not want a directional movement to condition his book or risk. To manage the risk, he must manage the delta of his book. The delta that you saw in the previous slide. The more the moneyness of our options changes, the more the market maker has to manage the risk. It basically does what we introduced.

[00:09:08.03] - Speaker 1
Delta hedging. Delta hedging is a risk management technique used to manage options positions. It involves adjusting the number of shares of the underlying assets by bought or sold in order to maintain a constant delta value for the option. By keeping the delta value constant, the sensitivity of the option's price to fluctuation of the underlying price is minimized, helping to manage risk. Let's take a very simple example.

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If we buy and add the money put, the market maker is short put and must sell the underlying. The at the money delta of an option is 50 Delta. For this reason, the market maker must short 50% of the value of the put to be delta hedged. The market maker continues to buy and sell the underlying based on the movement of the delta. As we can see, by buying or selling shares, the market maker adds or removes liquidity and this directly affects the price of the underlying shares.

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The more the price of the underlying changes, the more the option delta changes. We have a lesson dedicated to this topic with Mentor Queue. We want to focus on the importance of analyzing the correlations between different markets. The option one is particularly important because it has a direct effect on the stocks we hold in our portfolio and also on the ETF we use for our asset allocation. Here are some interesting stats from Goldman's research on option volumes during COVID Option volumes surpassed equity volumes in 2021 for the first time in history.

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At the beginning of this lesson, we explained how option volumes have increased exponentially in recent years. The volumes reached one of their highest level in 2020-2021 when we had several short squeezes that sent shares with bad fundamentals skyrocketing. These short squeezes are caused by a combination of investor and market makers activity creating a large short term price rally. But let's first understand what a short squeeze is. A short squeeze is a situation where investors who have taken bets against the stock by shorting it are forced to close their position at a loss because the price is rising rapidly.

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When an investor shorts a stock, they borrow shares and sell them to the market with the hope that the stock price will fall. They then plan to buy back the shares at a lower price, return them to the lender and profit from the difference. If we have a bearish view on an underlying, we can trade in two ways. We can short the stock. In this case, we will sell shares that we do not own with the idea of buying them back at a lower price in the future.

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In this case, the broker lends us the shares in exchange for an interest and a margin to guarantee the position. We could also be buying put options, but in this case we have to bear a cost for the purchase of these options which is the option premium. By buying options the risk is limited to the premium, while by selling shares the risk is potentially unlimited. Investors who sell shares might be forced to close their position if the market goes against them to avoid further losses by closing the short positions, buy orders are entered and this pushes the prices up. It is called short squeeze precisely because a strong upward movement is created due to the closure of these shorts.

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The closing of these shorts further drives the share price up. This can create a spiral where the stock price continues to rise causing greater losses for investors who are short and are forced to close their position. This can fuel the continued price rise of the stock. If the price rise is driven by the increase in volumes on call options which as we know have financial leverage, this creates exponential growth. An example is the Gamestop case which reached $347 with a growth of 1700% in just a few weeks.

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Here we can see the normal price movement of a stock sideways or bearish on the left hand side. At this point investors begin to short the asset. This puts bearish pressure on the asset. If the market goes up, short sellers start having liquidity problems because they have to start paying margin calls. If a short seller receives a margin call from a broker, he must guarantee more liquidity to keep the position open.

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If he does not have enough liquidity, the broker closes the position at a loss. The more the price increases, the more the margin calls and the pressure on the short seller cash flow increases. The short sellers stay in the position if they have the ability to continue paying margin calls. But in some cases this is not possible and that's why the short seller closes their shorts. This has the effect of driving the market higher and it removes the bearish pressure from the shorts.

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And here begins the short squeeze which brings the price up very quickly. This means that the margin calls increase. The more they increase, the more the shorts are closed, leading the market more and more to the upside. This continues up to the peak of the squeeze. Once all the shorts have been closed, the market pivots and in many cases begins to move down or sideways.

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Now let's look at what happened with GameStop. GameStop sells video games primarily through its physical stores. In recent years, with the growth of E commerce and online video games, the company has seen its market share and margin decrease. In mid January of 2021, a battle almost arose between retail investors on one side and some hedge funds on the other. On one hand the retailers were trying to bring the price up while on the other the hedge funds were trying to short it since, according to the analysts of these funds, the company had bad fundamentals.

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WallStreetBets is a group on Reddit where millions of people discuss investing. It is a forum where everyone is free to express their opinion and share their ideas. In June 2019, a WallStreetBets user began buying call option on GameStops. Expiring in January 2021, the bet was that the company's stock would rise. Michael Burry, the famous investor in the movie the Big Short, also claimed to have acquired 3% of GameStop shares.

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From then on, after a series of events, retailers began buying stocks and call options to drive up the price and trigger a short squeeze while hedge funds continued to short. The price rise was such that hedge funds decided to close the shorts, leading to the sudden increase in the price. A 1000% increase in one week. Many hedge funds have sadly lost out. First of all Melvin Capital, which due to the GME case received a bailout from Citadel and 0.72 for $3 billion.

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This is just the first in the list of funds that have suffered double digit losses on GameStop. But why does this happen? And what does the market maker have to do with it? The GameStop case led retail and non retail investors to excessive speculation throughout the purchase of large volumes of call options, forcing the market maker to buy shares of the underlying stock to remain delta hedged. At the same time, when the shorts are closed, it pushes the price higher because there is no more bearish pressure.

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Looking at the previous slide, we see how the volume of call options on GameStop was particularly high compared to the past. It is important to introduce the concept of open interest of options. You can find it on barchart.com or other brokerage platform or research tools. Open interest represents the number of derivatives contracts such as futures and options not yet closed at a specific point in time. It is often confused with traded volumes, but there are particular differences.

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Open interest changes daily and it is an important indication of liquidity. While in the stock market, the number of shares available, also called shares outstanding of a company, remains the same. In the case of derivatives, this aspect changes. Open interest also represents new liquidity that is entering the derivatives market. If a new buyer buys new options contracts, this increases the open interest.

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The greater the open interest, the greater the activity of the participants on stock and therefore the activity of the market maker. Here we can see an example of open interest in the GameStop share. Going back to the previous example, this speculation, as you can see from this chart, has pushed the price higher. In the red square. You can see how the price of GameStop has had an exponential rise compared to the historical average.

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Now the first ones who bought call options have gained because at those levels the volatility and the price were low. The first investors benefited from the rise in the price, but also from the increase of volatility. Those who entered late lost out even as the price continued to rise. During the course you will learn why in some cases, being long on a call even when the price rises does not necessarily mean a profit. This is due to volatility and the Greek Vega.

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We will talk about this in great detail. Don't worry.