Wall Street is increasingly uncomfortable with options-driven momentum trading that has helped push the S&P 500 into record territory.
As demand for bullish call options hits its highest level in years, some analysts have set their sights squarely on Nvidia Corp.’s NVDA,
Wednesday’s earnings report warns that it could be the catalyst that holds back this trade, potentially reversing a substantial part of the market’s rally over the past four months.
Their reasoning is rooted in the fact that investors are so enthusiastic about risky options bets that the mere fact that the earnings report is approved could be enough to sink the major US stock market indexes due to the internal dynamics of the options market : Even if Nvidia’s results met Wall Street’s expectations, according to several derivatives experts surveyed by MarketWatch.
According to FactSet, analysts expect Nvidia to report earnings per share of $4.59, an increase of more than 700% from the same quarter last year.
See: Nvidia could shine again when it reports on Wednesday
Traders are investing in bullish options at the fastest pace since the meme stock frenzy of 2021
As stocks have rallied over the past year, catching many on Wall Street by surprise, investors have increasingly relied on options to chase the market higher and boost returns.
That has sent demand for bullish out-of-the-money calls on major U.S. stocks nearing the most distorted level since 2021’s meme-stock craze, according to data from Cboe Global Markets, a major trader of options trading. .
An option is said to be trading “out of the money” when the exercise price of the option is higher than the trading price of the underlying stock or index, in the case of calls, or lower than it, in the case of calls. put.
In the options market, “skew” typically measures the demand for out-of-the-money calls relative to out-of-the-money puts, or the demand for out-of-the-money puts or calls relative to their at-the-money. -monetary counterparts. In this case it is the first.
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A key difference between the meme-stock era and the latest options market frenzy is that this time most of the action is in stocks heavily weighted in major market indexes, said Michael Lebowitz, portfolio manager at RIA. Advisors.
“Options buyers are typically more insurance buyers. But now they are more speculative traders, that’s what the bias tells you,” she said during an interview with MarketWatch.
Michael Kramer, a longtime independent stock market analyst and founder of Mott Capital, said Nvidia’s earnings could represent a decisive moment for the market, but the odds are stacked against the chipmaker.
“In my opinion the market has placed a gigantic bet on a company,” Kramer said. “If Nvidia doesn’t step up significantly, what’s going to make this thing keep going higher?”
With the stock already up nearly 50% this year, Nvidia has contributed about 25% of the S&P 500’s 4.9% advance since the start of 2024, Kramer said.
On Thursday, Nvidia’s tilt hit its highest level since June, according to data from SpotGamma, which provides data and analysis on the derivatives market.
Kramer said most of the stock’s rally in recent months has been driven by aggressive call buying, which forced options market makers to take shares of the underlying stock to cover their positions.
The rally is poised to reverse following Nvidia’s gains
As Nvidia has become the poster child for business momentum, many other stocks have followed suit. That’s why Brent Kochuba, founder of SpotGamma, believes the broader market could decline next week, along with Nvidia, as bullish call options tied to a number of major U.S. companies are likely to decline after the chipmaker reports its useful.
Once Nvidia’s earnings report is approved, implied volatility in the options market is likely to decrease, Kochuba explained. This would be a typical reaction: Implied volatility increases when investors see potentially market-influencing events in the future that they want to hedge against or speculate on. The opposite often happens when these events escape the market.
As implied volatility declines, options would become cheaper, while allowing market makers who sold them to sell some of the accumulated shares to cover their positions.
“Anything with strong call bias could feel a little more selling pressure” after Nvidia’s report on Wednesday, Kochuba said in a note to clients shared with MarketWatch.
Options market makers typically purchase stocks or index futures to hedge their positions because, if an option goes into the money, they may be in a position to deliver the underlying security.
Many other tech names are seeing extreme call option distortion, especially semiconductor names like Advanced Micro Devices Inc. AMD,
and ARM arm positions,
as well as other Big Tech giants such as Microsoft Corp. MSFT,
as traders bet Nvidia’s rising tide could lift the broader information technology sector.
Many on Wall Street, including Kramer, are uncomfortable with the role the options market has played in pushing the broader market higher since October, particularly as investors have curbed their expectations for the number of rate cuts. interest from the Federal Reserve this year. , while earnings outside of a handful of mega-cap tech stocks have generally been lackluster, Kramer said.
The torrid market advance has led to stocks trading at their highest levels relative to expected earnings in more than two years, while major stock indexes such as the S&P 500 and Nasdaq-100 have marched into record territory, while analysts’ expectations of Wall Street corporate earnings growth in 2024 declined.
The S&P 500’s ratio to full-year expected earnings recently topped 20 for the first time since the start of 2022, surpassing the five-year and 10-year averages, according to FactSet data.
The forward P/E ratio for the Nasdaq-100 NDX is even higher and was trading north of 26 on Friday.
“Stocks don’t trade on earnings momentum. They are trading on multiple expansions,” said Kramer of Mott Capital.
Momentum breeds momentum
To be sure, just because momentum has helped push stocks higher doesn’t mean traders can easily make a profit by betting that momentum will reverse imminently. As is often the case on Wall Street, momentum usually breeds momentum.
“The pace of these rallies isn’t really sustainable — and in the case of something like Nvidia, it sets a pretty high bar to outperform earnings — but the moment when the momentum fades is always the hard part,” said Bret Kenwell, options USA. investment analyst at eToro.
U.S. stocks closed lower during the final trading session of the week, with the S&P 500 SPX and Nasdaq Composite COMP snapping five-week winning streaks. The Dow Jones Industrial Average DJIA,
on the other hand, he managed to extend his winning streak to the sixth consecutive week.
Aside from Nvidia’s earnings, next week’s calendar of potentially market-influencing events seems pretty slim, other than the release of the Fed’s January meeting minutes.