{"id":11291,"date":"2024-03-19T11:30:00","date_gmt":"2024-03-19T15:30:00","guid":{"rendered":"https:\/\/ibkrcampus.eu\/uncategorized\/fomo-insurance-dominates-key-equity-options\/"},"modified":"2024-03-20T10:54:38","modified_gmt":"2024-03-20T10:54:38","slug":"fomo-insurance-dominates-key-equity-options","status":"publish","type":"post","link":"https:\/\/www.interactivebrokers.eu\/campus\/traders-insight\/securities\/options\/fomo-insurance-dominates-key-equity-options\/","title":{"rendered":"“FOMO Insurance” Dominates Key Equity Options"},"content":{"rendered":"\n

It may seem like a quaint notion to a new generation of YOLO-inspired speculators, but options markets arose as a way to transfer and hedge risk.  When we view options pricing data for some outperforming stocks, we see that FOMO is the main risk that is being hedged.<\/p>\n\n\n\n

The key to the prior assertion involves understanding the concept of options \u201cskew\u201d.[i]<\/a>  When we plot the implied volatilities of each options strike for a given expiration, they typically show a non-linear output.  It is normal to see a curve with a low ebb at-market or slightly above-market, with higher implied volatilities prevailing for below-market options than for those of similarly above-market options.  Below is a graph showing skews for S&P 500 (SPX) options for the next three monthly expiries.  The skews are relatively typical for a given stock or index:<\/p>\n\n\n\n

Skews for SPX Options Expiring on April 19th<\/sup> (lilac), May 16th<\/sup> (yellow), June 20th<\/sup> (orange)<\/em><\/strong><\/h3>\n\n\n\n
\"Skews<\/figure>\n\n\n\n

Source: Interactive Brokers<\/em><\/p>\n\n\n\n

<\/a>Past performance is not indicative of future results<\/p>\n\n\n\n

Now, let\u2019s compare that to the same set of skews for Nvidia (NVDA).  The differences are stark!<\/p>\n\n\n\n

Skews for NVDA Options Expiring on April 19th<\/sup> (yellow), May 16th<\/sup> (orange), June 20th<\/sup> (red)<\/em><\/strong><\/h3>\n\n\n\n
\"Skews<\/figure>\n\n\n\n

Source: Interactive Brokers<\/em><\/p>\n\n\n\n

<\/a>Past performance is not indicative of future results<\/p>\n\n\n\n

By the way, the odd skew is not unique to NVDA.  Here the same skew chart for AMD:<\/p>\n\n\n\n

Skews for AMD Options Expiring on April 19th<\/sup> (yellow), May 16th<\/sup> (orange), June 20th<\/sup> (red)<\/em><\/strong><\/h3>\n\n\n\n
\"Skews<\/figure>\n\n\n\n

<\/a>Past performance is not indicative of future results<\/p>\n\n\n\n

The skews for May and June NVDA options are essentially the inverse of those of SPX, while the April skew is almost linear.\u00a0 April AMD options are flat through most near-money strikes and flat for outer months.\u00a0 Let\u2019s consider why.\u00a0 (Note that for both stocks, the highest overall volatilities are for options that cover each stock\u2019s next earnings date. AMD earnings are expected after April expiration; NVDA after May\u2019s.)<\/p>\n\n\n\n

Remember, options pricing models utilize a series of well-known inputs, which include things like strike, expiration, underlying price, dividends, interest rates, and the like.  The key variable input is implied volatility.  We know the historical volatility of a given stock, but we\u2019ve all heard ad infinitum that past performance is no guarantee of future results.  Implied volatility reflects the market\u2019s best estimate of what might occur during the remaining life of the option, and those estimates are heavily influenced by supply and demand.[ii]<\/a> <\/p>\n\n\n\n

The customary skew curve shown above for SPX reflects typical views of risk vis-\u00e0-vis supply and demand.  The simplified explanation follows.  The relatively depressed upside skew reflects the natural supply of options from covered call writers, while inflated downside skew reflects a continual demand for hedging.  Remember, covered call writing is a far more popular strategy than cash-secured or naked put selling, so the sellers of \u201cinsurance\u201d need to be incentivized to offer it. <\/p>\n\n\n\n

Instead, what we see in NVDA is the opposite set of motivations.  We have used the term \u201cweaponized FOMO\u201d to refer to the rabid demand for the best performing AI-related stocks, with NVDA being that sector\u2019s leader.  The stock\u2019s steady ascent has radically changed the supply\/demand balance.  NVDA\u2019s spectacular rise has brought out waves of speculative call buyers, while traders have less incentive to write calls on a stock that is rapidly rising.  They don\u2019t want to risk having their shares called away.  In fact, we have seen many covered call writers flip to become buyers — they decided to buy back their short call positions rather than incur the short-term tax liabilities that would result from having their shares called away. <\/p>\n\n\n\n

Another source of demand for upside calls is from institutional buyers.\u00a0 While it could easily be written off as mere speculation, I will assert that their call purchases are hedging a specific risk.\u00a0 Remember, FOMO is a very real concern for institutional investors.\u00a0 As we explained in November<\/a>:<\/p>\n\n\n\n

While individuals are often perceived as being more susceptible to FOMO, it actually hits professionals more directly.  No portfolio manager wants to underperform his benchmark and peers, so they need to be afraid of missing out. <\/em><\/p>\n\n\n\n

An investor might not want to purchase a hot stock at or near all-time highs but might also be unwilling to miss out if the rally continues. Call options allow FOMO-fearful investors to participate in a stock\u2019s upside while limiting their downside risk to the initial premium outlay.  In other words, upside calls allow the portfolio manager to purchase \u201cFOMO insurance.\u201d  There are topsy-turvy corners of the equity markets right now \u2013 this was the explanation for one of them.<\/p>\n\n\n\n

—<\/p>\n\n\n\n

[i]<\/a> For those seeking a deeper understanding of skew, check out this IBKR Campus webinar: Understanding Option Skew | IBKR Webinars | IBKR Campus<\/a><\/p>\n\n\n\n

[ii]<\/a> More about these concepts here: Making Sense of the Three Types of Volatility | Traders’ Insight (ibkrcampus.com)<\/a><\/p>\n","protected":false},"excerpt":{"rendered":"

It may seem like a quaint notion to a new generation of YOLO-inspired speculators, but options markets arose as a way to transfer and hedge risk. When we view options pricing data for some outperforming stocks, we see that FOMO is the main risk that is being hedged.<\/p>\n","protected":false},"author":4,"featured_media":10033,"comment_status":"open","ping_status":"closed","sticky":true,"template":"","format":"standard","meta":{"_acf_changed":true,"footnotes":""},"categories":[145,147,18,8,12,148,7],"tags":[1256,1257,747,353,1258,379,935,1259,1121,1260,1261,1262],"contributors-categories":[149],"class_list":{"0":"post-11291","1":"post","2":"type-post","3":"status-publish","4":"format-standard","5":"has-post-thumbnail","7":"category-ibkr-market-insights","8":"category-north-america","9":"category-options","10":"category-region","11":"category-securities","12":"category-text-articles","13":"category-traders-insight","14":"tag-amd","15":"tag-covered-call","16":"tag-fomo","17":"tag-implied-volatility","18":"tag-institutional-investors","19":"tag-nvda","20":"tag-options-market","21":"tag-options-skew","22":"tag-portfolio-management","23":"tag-risk-hedging","24":"tag-speculative-trading","25":"tag-stock-market-dynamics","26":"contributors-categories-interactive-brokers"},"pp_statuses_selecting_workflow":false,"pp_workflow_action":"current","pp_status_selection":"publish","acf":[],"yoast_head":"\n“FOMO 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