Weighing Options

There’s no denying the connection between tulips and derivatives in 1636.

The Dutch Tulip Mania is often cited as the archetype for asset bubbles and the madness of crowds. It might better serve to inform our understanding of derivatives risk. In 1636, according to some accounts, tulip bulbs became the fourth largest Dutch export behind gin, herring and cheese. But there were not enough tulips to meet demand so rights were optioned and prices mushroomed through futures contracts. People made and lost fortunes without ever seeing a tulip.

While facts are fuzzy about this 17th century floral fervor, there’s a lesson for 2016 equities. Grasping the impact of derivatives in modern equities is essential but options are an unreliable surveillance device for your stock.

I’ll explain. ModernIR quantifies derivatives-impact by tracking counterparty trade-executions in the percentage of equity volume tracing to what we call Risk Management. We can then see why this implied derivatives-use is occurring.

For instance, when Risk Management and Active Investment are up simultaneously, hedge funds are likely behind buying or selling, coupling trades with calls or puts. If Risk Management is up with Fast Trading, that’s arbitrage between equities and derivatives like index options or futures, suggesting rapidly shifting supply and demand (and therefore impending change in your share-price). Options won’t give you this linkage.

Dollar-volumes in options top a whopping $110 billion daily. But 70% of it is in ETFs.  And almost 48% ties to options for a single ETF, the giant SPY from State Street tracking the S&P 500.

As Bloomberg reported January 8, SPY is a leviathan instrument. Its net asset value would rank it among the 25 largest US equities, ahead of Disney and Home Depot. It trades over 68 million shares daily, outpacing Apple. It’s about 14% of all market volume.  Yet trading in its options are 48% of all options volume – three times its equity market-share.

Why? Bloomberg’s Eric Balchunas thinks traders and investors are shifting from individual equity options where demand has been falling (further reason to question options for surveillance) into index options. SPY is large, liquid and tied to the primary market benchmark.

Bigger still is that size (pun intended) begets size, says Mr. Balchunas. Money has rushed – well, like a Tulip Mania – into ETFs. Everyone is doing the same thing. And just a handful of firms are managing it.  Bloomberg notes that Blackrock, Citigroup, Goldman Sachs and Citadel are the biggest holders of SPY options. Three of these are probably authorized participants for ETFs and the fourth is the world’s largest money manager and an ETF sponsor.

Mr. Balchunas concludes: “The question is how much more liquidity can ETFs drain from other markets—be they stocks, commodities, or bonds—before they become the only market?”

SPY options are an inexpensive way to achieve exposure to the broad market, which is generally starved for liquidity in the underlying assets. As we’ve written, ETFs are themselves a substitute for these assets.

The problem with looking at options to understand sentiment, volatility and risk is that it fails to account for why options are being used – which manifests in the equity data (which can only be seen in trade-executions, which is the data we’ve studied for over ten years).  If Asset-allocation is up, and Risk Management is up, ETFs and indexes are driving the use of derivatives. These two behaviors led equity-market price-setting in 2015. If you were reporting changes in options to management as indications of evolving rational sentiment, it was probably incorrect.

In the Tulip Mania, people used futures because there was insufficient tulip-bulb liquidity. The implied demand in derivatives drove extreme price-appreciation. But nobody had to sell a bulb to pop the bubble. It burst because implied future demand evaporated (costing a great lost fortune).

Options expire tomorrow and Friday, and next Wednesday are VIX expirations (two inverse VIX ETNs, XIV and TVIX, traded a combined 100 million shares Tuesday). Vast money in the market is moving uniformly, using ETFs and options to gain exposure to the same stocks. This is why broad measures don’t yet reflect the underlying deterioration in the breadth of the market (the Russell 2000 this week was briefly down 20% from June 2015 highs).

And now you know why. People tend to frolic in rather than tiptoe through the tulips. Be wary when everybody is buying rights.