The Wall Street Journal Google Your News Update

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Luke Vargas : After a summer stock rally, stocks have reversed in recent days. And if there’s one word to describe the markets now, it’s volatility. And behind that rising volatility, at least according to some strategists is options trading and hedge fund activity. I’m Luke Vargas with The Wall Street Journal and here to make sense of what’s going on in the markets, and how options could fit into that is Wall Street Journal markets reporter, Eric Wallerstein, who’s joining us from New York. Eric, welcome. Thank you for being with us.

Eric Wallerstein: Thank you, Luke. It’s a pleasure.

Luke Vargas : Pleasure’s mine. Could you start with the basics here? What are options?

Eric Wallerstein: It’s a great question, because I think a lot of people in the market are just unfamiliar with what’s going on in the background. So options from like a 30,000 foot view are just a way to bet on an underlying security, and you can bet that it’s going to go down or that it’s going to go up. So if I’m buying a call option, I’m betting that the S&P 500 or even a specific stock, like Apple is going to go up to some certain price in the future. If I’m buying a put option, then I’m betting that that price is going to go down. And options are unique because they’re cheaper than buying the actual index or the actual stock. And you don’t have the obligation to buy that security. So let’s say, I bet Apple will rise to $1,000 in a month. If it does, then great, I can buy Apple at the price. And if it doesn’t, that’s okay, I just lose a little bit of money I paid for that contract. So it’s a really unique way to bet on the direction of where things are going.

Luke Vargas : So Eric, who’s trading these options and why is this trading activity really all that consequential at a higher level?

Eric Wallerstein: So I think there’s a combination of people in the market trading these options. On one hand, you have smaller players trading options on Apple, or AMC, or GME or all these meme stocks you’re hearing about. And then a little more opaque and something you might not notice or hear as much about are these big institutions that are also trading options. Larger institutions tend to buy insurance. So they’ll like to hedge their bets, or they’ll also enter the options market to try and earn a little bit of money by selling options. Options activities really surged across the board, a ton of individual investors have come into the market and even institutions are still upping the amount that they’re transacting an option. So we’re on pace to break another record this year, in terms of total options transacted. We’re looking at over 40 million contracts a day. It just kind of points to how much that these options are really impacting things in the background. So when markets go up or down in the background, these options dynamics are actually influencing that, helping either aid them along the way and push up a rally, or if there’s a crash to the downside, they can help accelerate that. So it’s really important to be aware of because you might think that there’s one bad event that happens and markets fall. But in reality, there’s things perpetuating that. So options are a little different than stocks. When I trade an option, there’s usually a bank or some sort of options dealer on the other side of that. And those dealers don’t like to take risks. They’re basically insurance providers. They don’t want to be exposed one way or the other. So they’ll also hedge their bets. That hedging behavior is really what’s in the background, perpetuating these market cycles. And it can either exacerbate moves one way or the other, it can influence volatility by making it spike, making it go down. And when those large banks are also transacting, it just kind of creates a vicious feedback loop.

Luke Vargas : So what’s been happening in the last few months? Let’s get to the heart of your most recent reporting here.

Eric Wallerstein: In the first half of the year, we had this brutal bear market, and a lot of the existing options that were bought for protection were worth a ton of money. People could cash in on that insurance. After a lot of those options expired in June, we were kind of left in this new regime. That new regime lends itself to lower volatility and higher stock prices, just reflexively feeding upon itself. The stock prices rise, we got more hedge funds coming into the market, and it’s really just a circular dynamic. These options’ expiration dates are kind of the trigger for these new regimes of whether we’re getting positive or negative feedback in the market. So we recently had another one in the third week of August and that kind of halted this summer rally that people have been pointing to. So each month, and then especially on quarterly dates, you get these big chunks of options that are expiring. As you get closer to the days that those options expire, their value can change drastically. And therefore the people who sold those options also have to hedge their bets and sometimes big swings. So an option worth X on August 15th could be worth two times that or half that very easily within one or two days of its (inaudible). So that’s when you get these big swings, because then people on the other side of these options have to hedge their bets even more. And then you get some more people coming into the market to try and help out at the end of a quarter. And then once it’s over and a bunch of options either expire, worthless or they’re worth a lot, we’re kind of open to this new potential regime. People have described it as a tinder box, a Schrödinger’s cat where you’re not sure what you’re going to get on the other side of it. So it’s really interesting and you’re kind of left open to this new wave of volatility if someone’s there to spark it. And obviously Fed Chair, Jerome Powell provided that spark recently.

Luke Vargas : That was Wall Street Journal markets reporter, Eric Wallerstein, joining us from New York. Eric, thanks so much.

Eric Wallerstein: Appreciate it, Luke. Have a good one.

Luke Vargas : To hear more stories about business and politics from The Wall Street Journal, ask your Google Assistant to play WSJ What’s News Podcast.