How stock options impact the market

The great beyond.  Stocks rose yesterday as traders chose to cheer positive earnings and look beyond the latest surge in COVID cases.  First time claims for unemployment benefits topped estimates leading to some head scratching but stocks powered forward despite the miss.

N O T E W O R T H Y

Ties – optional.  It’s not too difficult to notice that stocks have been swinging around a lot in the past several months.  I am not necessarily referring to index volatility, which is tracked quite effectively by the various VIX indices.  I  am referring to individual stocks… which of course, make up those indexes. We all know by now that there is a bigger retail presence in the market which was thrown into sharp focus last year as the meme stock AKA reddit stock AKA chatroom stock became a thing. We also know that the intense shorter term, retail speculation is not limited to just those stocks like GameStop, AMC Entertainment, and Nokia. Investors of all shapes and sizes are looking to cash in on market moves across the board as access to the markets, information, and low cost trading becomes more prevalent.

I am sure that you have heard the celebrated story about Joe Kennedy, the famous father of the famous President John F Kennedy, who exited all of his stock positions on the eve of the great stock market crash of 1929 after receiving stock tips from a shoeshine boy on his way to the office.  He famously relayed that “when your shoeshine boy gives you stock tips, you know that it is time to get out of the market.”  Nobody is actually sure if he said it, if he did it, or what he actually said, but the story has become somewhat legendary on Wall Street and Main Street.  It is actually an interesting way of relaying another Wall Street postulate known as the odd lot theory.  Stocks used to be traded in round lots of 100 shares. Because those round lots were costly, it was assumed that if someone was seeking to trade an odd lot, less than 100 shares, that they were a small and unsophisticated investor. Also, back in those days, timely information was hard to come by, and was reserved for big fish and insiders.  So round-lot-big-shots moved the markets, and when they knew that the market had run its course they would exit.  By the time, the odd-lot-little-shots got the information, it was too late, as they were most likely still getting into the market.  In internet / stock meme terminology, those odd lot investors were left holding the bag.  

Well, as you know, things are a bit different these days.  For one, I have not seen a shoe shine boy in quite some time, though there is a great shoe shine store near my office and I am looking forward to when it opens back up in the recovery.  Today, of course we have the internet, which is bristling with all sorts of information and all matter of opinions, good, bad, and otherwise… so no lack of information.  Back in the day, you had to know a broker or some sort of financial “expert” in order to even buy a stock, while today, access to the markets is simple, cheap, and literally at your finger tips.  That said, I have the good fortune of having a great barber near my home.  If you know me, you would know that my beard needs more tending than my hair, but nonetheless, I enjoy visiting with Ed and his crew because I enjoy their company, and I do leave his shop smelling nice, a bit more neatly composed, and … with a handful of… stock tips.  You see, we talk about all sorts of interesting things like music, food, adult beverages, welding, bike riding – you name it.  But inevitably, stock investing always seems to come up.  Now, I know that I am generalizing, but I am usually the oldest guy in the shop, and customers along with the friendly barbers are typically all a part of the stock conversation.  It would be really easy for me to say to myself “what would Joe Kennedy do?”  But I  don’t, why? Because when those merry men talk stocks with me, they are usually very well informed about the news, fundamentals, and trends… hardly unsophisticated. Ed usually abbreviates his stock-related stories with something like “I am only buying small positions for short term.” Ok, so he is an odd-lotter in the classic sense.  I also know that he, like so many people in his age group use options as an inexpensive way of buying bigger positions.  You see, 1 stock option entitles you to receive or dispense of 100 shares of the underlying stock, and options are far cheaper than getting directly involved in the stock itself. But, what does that mean to us?

These days, lots more people are involved in the stock market as we have all probably had similar experiences to mine with my friends at the barber shop, but something is very different today than during the time of Joe Kennedy’s famous prediction. When a dealer sells, or writes an option to a retail investor like my friend Ed, it typically hedges the position by entering the market and buying or selling the underlying stock.  So if it is a call option and the stock is trading close to the strike price, the dealer might go out and buy 100 shares of the stock in case the holder calls the stock.  Of course this is not the rule and dealers will not likely trade 100 stocks for 1 option, but the hedging does very much occur around strike prices and nearer to expiration, and that hedging absolutely impacts the movement of the underlying stocks.  If my friend were to buy an Apple call option which expires next month with a strike price of $148, he would pay a $4 premium which would entitle him to buy 100 shares of Apple, so he is paying just $400 to control roughly $14,680 worth of Apple stock.  If a dealer believes that Apple has a good chance of getting to $148 and beyond (it closed at $146.80 yesterday), it might go out and buy that 100 shares for $14,680 to ensure that they, the dealer, don’t end up holding the bag.  The moral of this story is that the next time your barber, manicurist, grandchild, shoe shine boy, or whatever offers you a stock tip… you should probably take them seriously.  Sorry Joe.

THE MARKETS

Larger cap stocks continued their positive trend yesterday, trading up on strong corporate earnings. The S&P500 traded up by +0.20%, the Dow Jones Industrial Average climbed by +0.07%, the Nasdaq Composite Index traded up by +0.36%, and the small cap Russell 2000 slipped by -1.55%. Bonds rose and 10-year treasury yields gave up -1 basis point to 1.27%.  Cryptos added +3.38% with Bitcoin climbing by +1.35%, and Ethereum jumping by +3.56% aided by kind words from Elon Musk.

NXT UP

– Markit Manufacturing Flash PMI (July) is expected to come in at 62.0, off slightly from last month’s 62.2 reading.

– Markit Services Flash PMI (July) may have eased to 64.5 from 64.6 according to estimates.

– This morning Honeywell, Schlumberger, Roper, American Express, and NextEra Energy beat, while Kimberly-Clark missed estimates.

– Next week will be chock-full of earnings along with Durable Goods Orders, more housing numbers, Consumer Confidence, GDP, PCE inflation numbers, and University of Michigan Sentiment. The FOMC will hold its policy meeting and presser mid-week, which will be closely watched.  Check back on Monday for calendars and details.