In recent months the stock market has been, to use a technical term, weird. This is down to more than the usual bumptious volatility of a bull market top.
The markets have been punctuated by wild jumps and crashes in unlikely names, from junk stocks such as GameStop to established companies such as ViacomCBS, after it was drawn into the Archegos debacle.
One factor in many of the strangest market episodes is the shadow cast by the equity options market.
Equity option taking volumes have surged in recent years. According to the NYSE, the average daily volume of trading in option contracts on equities and exchange traded funds went from 17.5m in 2019 to 27.7m in 2020. This year the market is on pace for more than 40m contracts.
This matters to those who still trade in the boring old plain-vanilla stock market because all those options to buy and sell shares have to be hedged by the dealers which offer them.
For “call” options to buy stocks, dealers often do this by buying the underlying shares. In the jargon, the amount of shares a dealer has to buy to hedge an option is the option’s “delta”. The delta depends on how likely the stock is to hit the strike price of the option, and the option’s expiration date.
Here’s the tricky part. The delta of an option changes with the price of the underlying stock. So if a stock really starts to run up, dealers of options in it have to buy more of it to hedge the options they have sold. This adds to the upwards price pressure, driving the shares up further and forcing the dealers to buy yet more shares, which in turn . . . well, you see where this is going. This kind of snowball was behind the more violent spikes in GameStop, a name retail option buyers piled into heavily.
The punchline is that the state of the equity options market at any given moment tells you something about pressures that will be subsequently felt in the equity market itself — and it should be possible to trade on this fact.
The rather unlikely standard bearer for this sort of trade is Lily Francus, a twenty-something PhD student in bioinformatics. Until recently, she was an amateur trader, but her funny and lucid social media and blog posts have won her a media presence, and she is now trading for a living.
Francus’ core concept is an indicator called Nope — the “net options pricing effect” — which is a rough-and-ready (or as she says, “hand-wavey”) gauge of the weight the options market is exerting on the stock market. It estimates the amount of the liquidity available in a certain stock or index that is being sopped up by options dealers’ hedging (it is only an estimate, because dealers have other ways to hedge than…
Read More: The Nope theory to explain volatility in equity markets