Tuesday, February 7, 2012

"Has Derivatives Deleveraging Fueled the Stock Rally?"

From Of Two Minds:
A mad scramble to avoid insolvency as Greek default becomes likely may be driving the rally in equities.
Deleveraging typically means selling assets to raise cash to meet margin calls or pay debts coming due. But there may be another twist to deleveraging that has fueled the manic market rally since late December. I am indebted to Peter C. of M3 Financial Sense for explaining this dynamic. 

To understand this non-intuitive dynamic, let's start with a simple example of how options work. If this is new to you, please stay with me, your head will not explode.... at least for awhile. 

An option is a financial instrument which grants you the right to buy X number of shares of a company at Y price (the strike price). One option controls 100 shares. An option is either a put (a bet the price will decline in the future) or a call (a bet the price will rise in the future).
An option is "in the money" when the stock price is above the call strike price or below the put strike price. For example, if you own one call option on Netflix (NFLX) at a strike price of $100, then your option is worth $2,900 ($29 per share) as of today because Netflix is trading for $129 per share. (There is also a time value in options, but let's leave that aside in this example.) 

So if you bought 10,000 options on Netflix (NFLX), whomever sold you the options is obligated to deliver 1,000,000 shares of Netflix to you (at the strike price of the option) upon expiration of the option. 

If your option is "in the money" as in the above example, the specialist who sold you the options will hedge his position so he can meet the obligation. If your options are just barely in the money, he might buy 250,000 shares of Netflix to cover his future obligation.
As your option becomes ever more valuable, i.e. becomes deeper in the money, the specialist has to increase his hedge up to the full 1,000,000 shares that he is obligated to deliver to you upon expiration. 

That purchase of 750,000 shares to cover his bet will drive the price of Netflix up.
Here is an important point about options and derivatives. In theory, the number of options should equal the number of outstanding shares. If there are 1,000,000 shares of a stock outstanding, then there shouldn't be more than 10,000 options contracts written and sold....MORE