It is very important to emphasise that options trading is for sophisticated and experienced investors and this report is not a recommendation to use options. This note is to explain what could be happening in derivative markets and the impact this trading could have on underlying equity prices.
The report in the Financial Times over the weekend about SoftBank’s foray into technology stocks could partially explain the recent moves in share prices of US tech stocks. In this note, I will put my equity derivative hat back on and draw upon my 30 years of equity derivative market experience, to try to put forward in simple terms what SoftBank has potentially done and, more importantly, what the ramifications these derivative positions may have for individual stock names like Apple between now and December.
It might be useful to first run through the types of derivative instruments SoftBank may have used to gain their exposure. The simplest instrument (and one of the most widely used) is a listed call option. Listed call options are tradeable securities over stocks listed on the US exchange, for example Apple. Each listed option has standard features determined by exchange (be it NASDAQ or NYSE).
- Expiry date – e.g. 18 Sept 2020
- Strike price – the set price at which shares are bought or sold when exercised (e.g. $120.00)
- Option type – American or European. American options can be exercised by the buyer at anytime prior to the expiry date whereas European options can only be exercised upon expiry.
- Shares per contract – each option contract usually covers 100 shares of the underlying security. So this explains how options give a buyer leverage.
- Options premium – the price of each option which is what you pay or receive per option contract when traded.
If, as an investor, you have a very strong and committed view on the direction a stock may trade or if a particular stock is very undervalued in your view, then using options is one of the mechanisms that sophisticated investors use to gain exposure. One of the stocks mentioned in the news reports is Apple. I have no evidence that SoftBank has made an investment in Apple options or not, but given it is widely held and very liquid, it is a good stock to use to make the point of this note.
Apple has completed its stock split this last month, so all the stock prices and options contracts referred to here have been adjusted for that split. Below is a chart of the Apple share price.
It is very evident that since late July, the share price has performed very well, without any significant news of earnings, product releases or corporate actions. What drove this performance had many investors scratching for logical explanation. If a significant investor made a decision in late July to get exposure to Apple, they could either buy stock or they could buy call options. Options is known as a zero-sum game, as both the buyer and seller are at risk. Whatever the profit the buyer makes, the seller makes the same loss. If there are no natural sellers of calls in Apple, trading desks from any of the major banks (e.g. UBS, GS, Citi, etc) may offer to sell the options at a price. This leaves the investment bank exposed should the stock rise, so they in turn buy shares in the underlying as a hedge. How many shares they buy is determined by the strike price of the option relative to where the underlying shares are trading at the time. This ratio is known as the “delta” of the option. If Apple were trading at $96 in late July, a September $96.00 call option would have a delta of close to 0.5. This means if Apples share price goes up by $10.00 per share, then the option price would go up by $5.00 per contract. If an investment bank sold this option to an investor, they would need to buy 50 shares of Apple to hedge the upside market risk. (1 contract at 100 shares per contract x 0.5 delta = 50 shares.) If the option buyer bought 50,000 contracts, then the investment bank would need to buy 50,000 x 100SPC x 0.5D = 2.5m Apple shares. That’s a lot of stock, especially when it’s trading at $96 per share.
Now, what has got the market’s attention is the number of very large open positions – in particular, strikes on Apple. As of the US close on Friday, here are some of the more notable positions. It should be noted that a typical open interest per series is somewhere between 10,000 and 30,000 contracts.
|Expiry Date||Strike Price $||Open Interest||Notional value if Exercised.|
Source: Bloomberg Data
Should one particular investor be holding some or all of these positions, then they have accumulated a significant stake in Apple, and depending on the price they bought each option for, some very significant profits. A marked to market profit, however, is not locked in – it needs to be realised.
What happens next is what has the market intrigued. If the investor chooses to exercise their call options, then they pay the strike price per share and take delivery of the stock. This is the best outcome, as a large long-term holder usually wants to own the shares. However, if the options strike price is well above the current share price at options expiry, then the options may not be exercised. In this case, the option buyer has lost his option premium, which is profit to the seller of the option (zero-sum game) but importantly the seller may have an underlying equity position they no longer need, and could possibly sell. Given the option open interest positions are public, and we know how many there are, it can be reasonable to make a rough estimation on the amount of stock that may be sold.
There are many different option series listed on Apple, covering a range of strike prices. The above table is just the larger positions that stood out in this writer’s eye. As option traders at investment banks dynamically hedge their positions on a daily basis, the underlying equity exposure changes constantly. No one person will know the true position of the long investor other than that investor themselves, as invariably sophisticated investors spread the risk across several investment banks. What I expect, given the recent publicity given to the position, is that the derivative markets could continue to add volatility to underlying equities certainly through to December, which goes past the US elections in November.
The views expressed in this article are the views of the stated author as at the date published and are subject to change based on markets and other conditions. Past performance is not a reliable indicator of future performance. Mason Stevens is only providing general advice in providing this information. You should consider this information, along with all your other investments and strategies when assessing the appropriateness of the information to your individual circumstances. Mason Stevens and its associates and their respective directors and other staff each declare that they may hold interests in securities and/or earn fees or other benefits from transactions arising as a result of information contained in this article.