Over the past two weeks I’ve been writing how I’ve turned cautious on the market with my main concern being the deterioration of market breadth. That is even as the indices were moving higher fewer and fewer stocks were participating in the rally. It was the strength in big cap tech names such as Facebook (FB), Apple (AAPL), Amazon (AMZN), Microsoft (MSFT), and Alphabet (GOOGL), known as “FAAMG,” masking the underlying weakness.
What’s interesting is that as you dig deeper it appears even those names weren’t as strong as appeared. Rather they were partially propelled by short term option activity, namely call buying.
I described the dynamic of gamma squeeze in this article in which it was taken to an extreme in the Gamestock (GME) saga. Essentially, buying out-of-the-money calls forces market makers who need to hedge into buying stock at ever higher prices.
Last year it was mostly retail traders playing the meme stocks to drive prices higher. Now it looks like institutional investors and hedge funds are getting in the game. Of course given the large dollar amounts they manage they need to do it in the largest names which can absorb the volume with enough size to move the needle on billions dollar portfolios.
Options trading activity has surged over the past two months. So far July has seen month-to-date average daily notional amount trading at a record. According to a report from Goldman Sachs (GS), roughly $534 billion of options have changed hands on average each day this month, with more than half of that happening in call options. That’s above last year’s average of around $367 billion.
Two other statistics of note; options with less than 2 weeks to expiry comprise 75% of all trades and 87% of all volume is concentrated in the 50 largest capitalized stocks.
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This option activity would help explain the surge in FAAMG earlier this month while none of the soldiers followed. To my mind these short-term option plays creating the gamma squeeze are unsustainable.
What’s interesting is last August in the middle of the low-volume summer doldrums, tech names exploded higher for several weeks in a move which stumped traders only for it to be revealed that the action was due to an attempt by SoftBank’s brand new public equity trading desk to ramp gamma higher in tech names.
You can see the parabolic move last August and then the subsequent steep correction.
I’m not saying the calling buying was or currently is the only force driving the indices, there are many factors at work. But it’s another piece of the puzzle that keeps me cautious. There may be another drive higher as we head into next week when MSFT, AAPL and Alphabet all report earnings. But for the Options360 service I’m getting ready to establish a new bearish position in Invesco Power Shares (QQQ) when I feel the timing is right.