Option Trading and Stock Market Bubbles

1/27/21

A recent article on the front page of the NY Times Business section authored by Matt Phillips charges that stock option traders are helping to foster a bubble in the stock market. The article reports that a measure that compares the volume of put option contracts to that of call options — the put-call ratio — is at a low not seen since the year 2000. The claim is that this low ratio is indicative of a level of market optimism that is serving to force the market higher.

This line of reasoning is flawed. Every option trade involves a buyer and a seller. Thus, while the call buyer is representing a bullish view, the call seller is either neutral or bearish. Similarly, while the put buyer is bearish, the put seller is neutral or bullish. Call option trading activity has always been greater than put option trading activity. That’s simply a function of calls being somewhat more intuitive than puts. That is, it’s easier to wrap our heads around the idea of a right to buy, as compared to a right to sell.

Here’s what is true: some portion of option traders engage in a practice called delta hedging, whereby they manage their risk by maintaining proportional exposures in the underlying stock — a long stock exposure for those who’ve sold calls or a short stock exposure for those who sold puts. This option-plus-stock position is initiated to insulate themselves from directional price moves. In so doing, the trader transforms the sold option position from a purely directional trade to more of a bet on volatility. Operationally, the proportion of stocks-to-options would have to be adjusted with changing stock prices.

With rising prices, both call sellers and put sellers will put in orders to buy shares; and with falling prices, call sellers and put sellers will sell more shares. Thus, the idea that the adjustment process may reinforce directional price changes has some merit, but it’s questionable if the population of delta-neutral option traders is of sufficient size to really have any significant influence. In any case, even if option sellers do have this kind of market authority, option contracts either get liquidated or they expire. At that time, whatever directional influence that the delta neutral adjustment trading may have initially had would be reversed when the stock trades necessarily have to be unwound.

It may make sense to investigate the influence that open interest of all stock option positions may have in reinforcing or discouraging directional trends in the stock market, but looking at put-call ratios is a misdirection.