The recent US equity market rally highlights the rise of a new kind of "all-in" retail investor, one that is ramping up leveraged trading through the derivatives market, primarily via call options, we take a closer look via this report by Allianz.
This unexpected market behaviour has sparked claims of a structural change in the functioning of capital markets.
However, this situation is not really new: Despite having to concede that the tools, outreach and amplification of the equity rally have structurally changed by the extensive use of social networks and other online platforms, most of the recent equity rally’s characteristics are common in a “late” equity cycle stage.
These include a reliance on leveraged investing to quickly multiply gains, signs of market manipulation/fraud starting to appear and, lastly, the Fear of Missing Out (FOMO) effect leading to overtrading.
But, why did retailers enter the stage now, in one of the biggest economic crises?
Four conditions were decisive for this development:
- Widespread and easy access to options trading, offered by trading apps since 2018.
- The surge in social media usage and proliferation of social media influencers as opinion leaders, creating an informal and ‘new’ way of mobilizing capital (e.g. targeting heavily shorted stocks).
- A significant reduction in transaction costs for derivatives and trades in the small-cap market segment, where they could easily become prohibitive: Transaction fees were cut to almost zero by some trading apps in early 2020 (although retailers are paying a wider bid-ask spread).
- The availability of liquidity with low opportunity costs: The first lockdown sparked an explosion in the saving ratio (in Q2 2020 26% of disposable income, disposable income increased by 13% y/y) amid falling interest on bank accounts and limited spending possibilities.
Extreme market rallies tend to happen in a staggered manner and this one was no different:
Initially, some early bidders enter into the stock, generating minor initial readjustments of future return expectations and making the stock appear in the daily equity leaderboard.
These early-bidders are normally followed by big investors that recognise the upside trend and invest accordingly (these big investors do not publicly disclose their positioning in the stock).
The melting pot of investors constitutes the base of an inverted pyramid.
Next, the rapid price appreciation triggers a “call” or “FOMO (Fear Of Missing Out)” effect that leads many small investors to participate in the “expected” disproportionate upside potential.
However, this call effect is well known as the rational inattention theory suggests that such a 5-sigma event paired with some market influencer suggestions may prove enough to trigger such an extreme repositioning. However, reality tends to prove quite harsh for most small investors, as this irrational effect leads them to enter the market near its peak.
Overall, this behaviour creates an unwanted “Ponzi scheme” dynamic, hitting those entering last.
Is the new wave of retail investors and rising options trading increasing financial systemic risk?
One possibility is a domino effect if some market participants need to cover their long-call position-related losses. Nonetheless, there might be a bigger issue building up as the liquidity needs generated by options trading may catch the financial system naked.
However, we do not expect ‘new’ retail trading on capital markets to pose an immediate risk for the normal functioning of the financial system.
However, the massive increase in options trading (not only by retail investors) may definitely create some instances of temporary liquidity shortages, which should not be structural but will create some unwanted volatility and raise some questions about ‘new’ brokers’ liquidity, more so as, interestingly enough, this situation leaves markets living in a paradox or contradiction:
- People use derivatives, in particular call options, because they believe there is too much liquidity chasing too few assets.
- However, derivatives trading is freezing some of that liquidity or sucking it out of the system because of margin deposits.
Click here for the full report.
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