SoftBank, Robinhood and a Margins Singularity
Last week we featured two pieces on short term price movements – first, Aswath Damodaran on the meaningless rally in Tesla and Apple on news of stock splits and second, Softbank’s big derivatives bets in tech. As Nasdaq continues to tumble this week as well, there is more clarity emerging on the role of derivatives in pushing up the rally. Here’s a blog that helps some of us ‘fundamentals-types’ to get a flavour of the trading world, especially super-charged derivatives trading. People have blamed the rise of algo trading, leverage (as money remains cheap) and derivatives as the reasons for the increasingly amplified moves in stock prices. This rather entertaining read attempts to help us understand how exactly that happens using the Softbank call options bet as an example. Ranjan Roy seems to enjoy taking a dig at everything Softbank, whether it is its WeWork and Wirecard fiasco or its decision to hire options traders to run the world’s largest tech fund.
“I still remember when I first learned that the head of Softbank’s Vision Fund was going to be an ex-Deutsche Bank credit derivatives trader. As someone from the bank trading world, I found it a bit odd. The moment I arrived at business school, I quickly realized that trading provided very few transferable skills relevant to the business world. You don’t even quite learn to invest, so much as financialize things (I’m not saying that’s a bad thing, just different). From what I understood, Rajeev had been involved in structured financial products, which are the opposite of understanding operational capacities and market sizes.”
But the crux of the piece is how buying derivatives at an abnormally large scale triggers a self-reinforcing move in the markets completely detached from fundamentals:
“The most important dynamic to understand is the people selling the call options have theoretically infinite losses.
The sellers of options need to hedge or cancel out all that risk. You can buy the underlying stock – that way if the stock runs up, you would lose money on the option you sold but make money on the stock you now own. You can buy a similar call option from some other market-marker. Both of these hedging actions would exert some kind of upward pressure on both the stock and the call option price.
This act of hedging your risk from selling options is known as managing your Gamma. According to Goldman back in June, “Gamma has the potential to be one of the most important non-fundamental flows in equity markets”.
It’s exactly that – a flow of money that has nothing to do with the fundamentals of companies or economies but is simply a weird momentum byproduct of options trading.
In a normal market, this risk-hedging wouldn’t have any real impact on the price of the stock itself. The amount of options being traded would be tiny relative to the amount of actual stock being traded. All this stuff would be taking place via transactions triggered in the background by automated risk systems and we would instead be analyzing earnings reports to assign long-term valuations.
There had, however, been talk of a secret “Nasdaq whale” that was buying up billions of dollars in call options”
Softbank was the NASDAQ whale.
“Try to understand the self-reinforcing aspects of a strategy like as follows:
SoftBank buys far more call options than the market is used to handling. The market-makers have now sold far more call options than they’re used to and need to hedge, meaning they’re going to be buying that underlying stock. That pushes the price up, meaning they will need to buy even more of that stock to hedge. And let’s not forget the COVID + software will eat the world stories, which are very true. Does anyone want to bet against Apple or Tesla or Amazon or Zoom or Shopify? What other stock are you going to buy?
This explains how a giant company like Zoom goes up 40% in just one day. There’s natural buying pressure from people excited about those amazing earnings, but these distorted market dynamics create a buying frenzy as the market-makers who are exposed to these run-ups have to buy more and more of the stock to keep their exposure down. They buy more stock to hedge which triggers algorithms somewhere else to buy more of that stock. Regular humans who just want to buy stocks get alerts about an amazing stock and also buy that stock. Which makes the market-maker who originally sold the option need to buy even more stock to hedge. That’s the Gamma Melt-up.”