is the options-driven selloff over?

My guess is that it is.

what happened

Let’s say you buy an exchange-traded call option (which is the usual kind) on XYZ stock through your discount brokerage account. This means you’re entering into a contract, typically with a big brokerage house on the other side, that gives you the right–but not the obligation–to buy (typically 100 shares of) XYZ at a specified price at any point over, say, the next three months. You pay a premium that’s basically a function of the length of time the contract is in force.

The Options Clearing Corporation Corporation makes sure that both sides have the wherewithal to fulfill their side of the bargain–in this case, that the brokerage house is able to deliver the shares if you exercise the option.

The brokerage house typically hedges its exposure by buying either XYZ shares or options or some other derivative instrument but typically not at 100%. Maybe 30% instead. As/if the price of XYZ begins to rise as new options buyers emerge, the broker not only hedges the new exposure but also boosts the percentage coverage to, say, 50%.

If the first option purchase triggered buying 30 shares of XYZ as a hedge, the second triggers buying of 70. If the stock price continues to rise, new options purchases cause the broker to buy increasingly large amounts of the underlying stock. At the same time, the pool of willing sellers of the stock begins to dry up. If this process continues, the result is a melt-up in the stock price of XYZ.

why I think it’s over

Brokers have learned that failure to follow their coverage rules immediately–on the idea that tomorrow will bring a better opportunity than today–is a recipe for disaster. So, like it or not, they act right away.

Once brokers are 100% hedged, the pressure to buy more abates.

Certainly Softbank, if not other option buyers as well, are aware of this phenomenon. Softbank may well have none its gigantic options buy with the intention of forcing, and profiting from, the meltup that happened.

Softbank quickly learned that its shareholders don’t want the company to have stock market speculation as its main moneymaker. For their part, I imagine brokers will be more fully hedged with new options contracts for a while at least, making a new meltup less likely.

what to do now

After dramatic market moves, it’s always good to reassess portfolio structure to see what went well and what didn’t–and fix problems you may find.

Looking for the stocks that are recovering strongly vs. ones that are lagging behind or still falling will give us clues to where the market may be moving next.

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