Rallying market fuels rising risks as investors keep raising stakes

(Originally published Nov. 4 in “What in the World”) Growing bets on the rising stock market are raising the odds of gut-wrenching turbulence.

The latest risk is building in the market for options—the derivative contracts that give you the right (but not the obligation) to buy (a call) or sell (a put) security at a certain price before a certain date. The attraction of options is that they cost just a fraction of buying the underlying security. That means that if the security’s price doesn’t rise beyond the target before the deadline, you lose the entire cost of the option. But if the security does exceed the strike price, profits can be several times the option’s cost.

With stocks on a seemingly one-way, record-setting tear, ebullient investors have been clamoring to buy call options so that, as the market rises, they can buy them at below-market prices, sell and pocket the difference.

For every buyer, though, there has to be a seller. And selling a call option is just about the riskiest bet you can make: technically the downside risk is unlimited. Options sellers, therefore, usually try to make sure that the market value of the securities underlying the call options they sell are balanced out by the underlying values of the put options they sell. The trouble is, with investors so confident in the market rising, there’s a big shortage of investors buying puts. That has resulted in options dealers holding a net surplus of call options.

Since that’s such a dangerous position to be in, options dealers tend to hedge the risk of big losses by playing the market, as Reuters explains, buying futures when the market is rallying and selling futures when it dips. (A futures contract, like a call option, is an agreement to buy a security at a certain price by a certain date. Unlike a call option, though, it’s an obligation—not an, um, option.) If the strategy works, it helps dealers build a buffer against paying out on those call options. But since stock prices tend to respond to movements in the futures market, their actions in the futures market tend to intensify movements in the real market.

The upshot: rising bets on the market are increasing the risk that the market becomes more volatile. That risk is already heightened by the Fed’s decision Wednesday to cut its benchmark interest rate by 0.25 percentage points. Investors expected that. What they didn’t expect was for Fed Chair Jerome Powell to cast doubt on another cut in December. As a result, investor confidence in a December rate cut has dropped from 94% to just 73%.

The Fed did, however, announce that it was ending its policy of “quantitative tightening,” in which it sold U.S. government bonds it bought with imaginary dollars when the economy was struggling, or let them mature without buying new ones. That effort was slowly draining cash from the economy, exacerbating a shortage of cash among banks and raising the risk of sudden shocks.

But announcing the end of QT hasn’t provided the immediate relief many thought it might. The Fed had been letting bonds it held mature without rolling them over, i.e. buying new ones to replace them. Now, it said last Wednesday, it will use the proceeds of maturing asset-backed securities from federal agencies to buy short-term U.S. Treasury bonds, or T-bills.

Despite the fact that this would potentially inject $15 billion into the market, a key gauge of liquidity jumped to a record last week, suggesting investors still expect money to get tighter.

Another trend compounding the risk of a massive market correction: the growth of leveraged ETFs. Like options dealers with a net surplus of calls, leveraged ETFs exacerbate price swing because their managers have to buy more shares to a stock if the price rises, or sell if it falls, to maintain the fund’s target level of leverage.

Potential for gut-wrenching price swings that force them into panic buying or selling are rising thanks to the dominance of a handful of Big Tech stocks over the market’s capitalization. The so-called Magnificent Seven stocks—Amazon, Apple, Google, Meta, Microsoft, Nvidia, and Tesla—now account for 37.4% of S&P500’s market capitalization.