According to JPMorgan Chase & Co., low liquidity can make stock markets particularly vulnerable to exaggerated moves around large option trades.
The large volume of options has caught the attention of investors in recent days – first when volatility started to rise with stocks, and then to reports that Softbank Group Inc. and others have invested billions in the derived products. A big concern is that liquidity remains low, according to JPMorgan’s derivatives strategist Shawn Quigg.
“Unusually large transactions in narrow markets open the door to larger fluctuations in the dealer’s gamma positioning, especially when executed in style factors / sectors that may already be considered overbought / sold,” said Quigg in an email Wednesday. Gamma refers to the drift in the price of options that brokers seek to compensate for by buying or selling the underlying stock. “This increases the potential for exacerbated stock movements as brokers hedge exposure.”
How options influence the stock market has become a pressing issue of late, with some analysts claiming that the precipitous rise of U.S. tech giants in 2020 is mainly due to dealers hedging the other side of these deals.
But others are skeptical: Benn Eifert, chief investment officer at QVR Advisors, said day traders had a much larger effect. John Griffin, a finance professor at the University of Texas at Austin known for reporting suspicious activity in the VIX and studying Bitcoin, said he doubted an investor could be responsible for the movements of these liquid tech stocks.
While retail traders may have played a role, they were not the primary driver, Quigg said.
Following the recent multi-day massive selloff, investors can take advantage of the high volatility – particularly in tech and dynamic stocks – by selling puts, he said.
Quigg and his colleague Peng Cheng recommended tail protection in a note Thursday: Sell 1x three-month on-the-money puts on the Invesco QQQ Trust Series 1 while buying three-month puts at 90%. at zero cost, they said.