A rough year for U.S. stocks has turned out to be a boon for options trading.
The average number of puts and calls changing hands surged 22% this year as the S&P 500 endured two corrections and stocks from banks to small-caps to tech giants sank into a bear market. At 20 million contracts a day, trading is poised to surpass the previous record of 18 million reached in 2011, according to data compiled by Options Clearing.
Demand for options, often used by investors to protect against declines in equity holdings, has exploded as volatility came roaring back into the market this year. The S&P 500 is ending 2018 with its worst December slump since 1931 as a litany of negative forces, including a less friendly Federal Reserve, lingering U.S.-China trade tensions and slowing economic growth threaten a bull market nearing its 10th anniversary.
“Given the political uncertainty, the economic uncertainty, options really have just become a much more efficient means of hedging risk and expressing viewpoints than they’ve been in a number of years,” says Julian Emanuel, chief equity and derivatives strategist at BTIG in New York. “They’re more valuable given the fact that this late in a cycle the range of outcomes expands as dramatically as clearly it has in the last six months.”
About 4.7 billion puts and calls traded on U.S. exchanges in the first 11 months of the year, exceeding any full-year total since OCC began tracking the data in 1973. Total volume would top 5 billion for the first time ever if volume continued at that pace in December.
The rush to the options market coincided with a rise in equity transactions, spurred by bouts of volatility that are getting more common. Traders flocked to derivatives twice this year, with daily volume spiking to 24 million contracts in February and again in October. In both instances, stocks sold off, each time erasing at least $3 trillion from equity values.
This explosion in trading reflects the growing popularity of a financial instrument whose implications for the cash market are getting hard to ignore. From put-to-call ratios to implied volatility, data on options is studied extensively at Wall Street behemoths such as Goldman Sachs and Credit Suisse to gauge investor sentiment.
Some theorize that derivatives wagers can influence prices of their underlying shares. That kind of “tail-wags-dog” scenario is one of the possible explanations Wells Fargo gave for the 5% rally in the S&P 500 Wednesday.
Strategist Pravit Chintawongvanich pointed out that some large options writers used a strategy called “condors,” which involves selling puts, or the right to unload stocks at a specific price. As the market kept falling, these traders were forced to buy back the options while selling fresh ones, therefore weighing on the market.
“We may have seen a ‘capitulation’ of sorts from one large player who has been selling condors,” Chintawongvanich wrote in a note. “They covered the deep in-the-money put spread, but did not sell a new one as they normally would. If they stop rolling put spreads, that could relieve some of the pressure on stocks. Moreover, if the market can rally back toward in-the-money put strikes, the selling flow from these players may become less of a concern.”
Whatever the case, it’s undeniable that the appetite for options is growing. Since crossing 10 million contracts a day in 2007, trading has risen in all but three years.
