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Options are derivative contracts as they derive their value from the price movement of the underlying stock. But can it be reversed? Can options contracts influence their underlying stock prices? Here we explain how options trading have an influence on stock prices.
How Does Options Trading Have An Influence On Stock Prices?
In theory, options don’t affect the stock price. But the reality is different. It is a debatable topic. Traditional investors say that options trading generally doesn’t impact the demand and supply of stocks. After all, options are nothing but “side bets”.
For instance, in a horse race, you place your bet on which horse will win. You can do all the math you like and come to a logical conclusion that Horse A will win. But your bet does not affect the outcome. Similarly, your options (side bet of strike price) do not affect the outcome (stock price).
But the new age Redditors and hedge funds are challenging this theory. Continuing on the horse race example, if a lot of money is at stake, the outcome could be manipulated, and the horse with the highest bet could lose. That is what Redditors and hedge funds are doing. They look at the position dominating in the options market and accordingly buy and sell shares in the spot market.
But both sides argument bring a common conclusion that options’ influence is short-lived, and the stock corrects to it fundamental valuation in the long term.
The Correlation between Options and Stock Price
To understand how options can influence stock price, you first need to understand the correlation between the two.
The options buyer gets the right to buy or sell shares at the strike price in the future, depending on where the stock price is. If the buyer decides to exercise the option, the seller of the option is obligated to abide. This means the seller takes the risk from the buyer in return for a premium, just like an insurance company. These options sellers are mostly institutional investors and are popularly called market makers.
The option is exercised when the stock price comes close to the strike price near maturity. Hence, market makers use complex tools to keep their risk in check. Two popular tools are:
Delta = Change in the option price for every $1 change in underlying stock price.
Gamma = Change in delta for every $1 change in underlying stock price.
Think of these Greeks like the game of hot and cold. When the underlying stock price approaches closer to the strike price, the Greeks are hot, and when the stock price is far from the strike price, they are cold.
How Gamma explosion Impacts the Stock Price
Gamma measures the change in the options price. Gamma is negative for options seller and is closer to -1 when the strike price is near the stock price. In layman’s terms, gamma tells the options seller the risk of the buyer exercising the option. It is like a quake alarm to detect an earthquake.
A squeeze comes when there is unexpected pressure on the stock price forcing investors with exposure to the stock to change their position. A gamma squeeze creates high seismic activity in the stock price graph.
When investors believe that a stock price will rise sharply in a short period, a large number of investors rush to buy short-dated call options, especially weekly call options. The seller of the call option is now at the risk of selling the underlying stock at the strike price. Let’s take an example.
Jake along with 99 other Redditors purchased one-week call options of stock A with the strike price of $31 on May 28. One call option gives them the right to buy 100 shares of stock A for $31. On June 1, stock A surged past $32, making all the 100 call options exercisable. The market makers are forced to buy more shares of A so they can hedge their short position and deliver 100,000 shares, pushing up the stock price. The gamma is high for market makers.
This pattern continues, and investors keep buying call options forcing institutional investors to buy more shares. Redditors do so because buying options are cheaper than buying stocks. For buying 100 shares of stock A, Jake will have to shell out around $3,200 against $500 for call options.
Now, this gamma squeeze inflates stock A to unprecedented levels. Suddenly Jake decides to sell stock A when it is trading at $51. Here Jake earns $28/share ($20 – $2 premium on call options). In gamma squeeze, the short position loses. If you notice, the activity in the options market influenced demand in the stock market and artificially inflated the price of the underlying stock.
AMC is the perfect example, as the gamma squeeze pushed the stock price up 372% between May 20 and June 20.
Pinning the Strike Price
Gamma squeeze is the extreme form of options impact on the stock price. Unlike gamma squeeze, “Pinning” is the most common and oldest form institutional investors use to alter the stock price and maximize their returns. If the open interest in a stock’s options is high, there is a higher chance of pining. Open interest means buyers and sellers of options have not yet closed the contract.
For instance, Jack sells 100 call options of stock X at a $115 strike price and earns a premium of $2/share. If the stock X reaches $115.5 a day before expiry, he will have to sell 100,000 shares to the call option buyer at $115/share. If the gap is not that big, Jack will buy enough shares in the spot market to pull the stock price down to the strike price of $115. This way, he can avoid the risk of option getting exercised.
If the stock X falls to $114.5 a day before expiry, then put option sellers would have a similar motivation. As per the put contract, they are obligated to buy shares at $115 if the stock price falls below the strike price. They will buy enough shares in the spot market to move the stock price to $115, so they won’t have to buy 100,000 shares for $115.
This back and forth of call and put writers pins the stock price to the strike price on the expiry date. But the pinning only brings a minor correction and only works for less volatile stocks.
Options do have an impact on the stock price, but it is temporary and is mostly near the option expiry date. Options trading is like a game of Price is Right, mostly time-bound and involves guesswork. Do not jump into complex options games like gamma squeeze without understanding the risks.