Wall Street’s key measure of stock-market volatility is at its lowest since the COVID-19 crisis took off in the US last year, but that calmness will likely break over the next few months, according to UBS.
The US stock market has soared to record highs in 2021 on the back of accelerating coronavirus vaccinations worldwide and roughly $5 trillion in financial aid deployed by the US government to mitigate the pandemic’s economic damage. The vaccinations and stimulus packages have been laying the groundwork for a further reopening of the world’s largest economy as people begin to rebuild work and school routines and spend the money sent to them by Uncle Sam.
The S&P 500 index has shot above the 4,100 level and the Dow Jones Industrial Average tracking blue-chips is at its strongest levels, driven by cyclical sectors such as energy and industrials that stand to benefit from increased economic activity.
Wall Street’s so-called “fear gauge,” at the same time, has dropped below the 17 level, the lowest since early February 2020, before the World Health Organization declared the coronavirus outbreak a pandemic. But don’t expect the Cboe volatility index to continue to stay that low, said the world’s largest wealth manager in a note published Friday.
UBS noted a news report that at least one investor bought about $40 million in VIX call options that indicate the buyer expects market volatility to pick up pace over the next three months. One or more investors anticipated the VIX to reach above the 25 level and rise towards 40 by mid-July, Reuters reported, citing trading data.
“We see reasons to expect periodic bouts of higher volatility in the near term,” said Mark Haefele, chief investment officer at UBS Global Wealth Management, in the note.
Growth vs inflation
Firstly, investors may be torn between optimism over accelerating economic growth and worries over higher inflation. Among the signs that recovery is taking further hold was the recent and strongest reading in services-sector activity since 1997 from the Institute for Supply Management. European growth should also strengthen as vaccinations increase.
“Still, as pent-up demand meets supply constraints, a pickup in inflation could well unsettle investors,” said the investment bank. This week, Dallas Federal Reserve President Robert Kaplan said inflation could rise “well in excess of 2.5%,” over the summer, which would be well above the Fed’s 2% target.
Investors have so far looked through news about variant strains of COVID-19. “This optimism could be put to the test by the spread of new variants of the virus, especially in areas where the vaccination effort has been progressing well, such as in the US.”
UBS noted “pockets” of rising infections in Ohio and Wisconsin.
Volatility has been “sporadically heightened” by a rise in institutional and retail activity in the options market, along with the increased share of growth stocks in major equity indexes, said UBS.
“In the first quarter we saw retail activity driving volatility in individual stocks, such as GameStop, which spilled over into broader market swings,” said Haefele.
Now, Congress and US regulators are reviewing what happened to see if there are any vulnerabilities in the stock market that need to be addressed. Regulators are considering rule changes on everything from options trading, to short-selling and gamification practices by investing apps like Robinhood.
On Tuesday, Senator Elizabeth Warren shared the responses to her previous letters that asked the SEC and FINRA how they planned to respond to the volatility in GameStop. The responses revealed a list of issues the regulators are now examining.
The SEC said it is evaluating if there are any gaps in its market manipulation rules. The agency also said it will “seriously consider” increasing the requirements for brokers that offer options trading, and increasing disclosure requirements for brokers that deal with payment for order flow and for hedge funds and investors that engage in short-selling.
FINRA, meanwhile, said its looking into the gamification of the stock market by investing apps like Robinhood, and whether its current rules adequately address the risks presented by these practices. Both FINRA and the SEC said they are still investigating if there was any wrongdoing related to the meteoric rise of GameStop earlier this year.
“The GameStop controversy revealed how the Wall Street game is rigged in favor of big hedge funds and giant corporations – and how this hurts individual investors and the economy. I’m going to keep fighting for answers, a level set of rules, and a transparent and open market for everyone,” Warren said.
A long position in investing basically means to buy or own a stock. Generally, you do so because you expect it to increase in value in the future – hence, you’re holding it for the long-term.
But a long position also has a specialized meaning, having to do with options and options trading. It refers to buying a specific kind of option, based on your belief as to where the price of a stock (or another asset) is headed.
Let’s examine how a long position in options, or “going long” as the traders say, works.
What is a long position in options?
In the options-trading world, taking a long position, or going long, means you’re purchasing an option. An option is a contract that gives you the right to buy or to sell shares for a preset price (or “strike price”) on or before a future date, usually within the next nine months. It’s an opportunity to do this trade, but not a commitment – so, an option.
There are two types of long options, a long call and a long put.
A long call option gives you the right to buy, or call, shares of a named stock for a preset price at a later date.
A long put option does the opposite: It gives you the right to sell, or put, shares of that stock in the future for a preset price.
How a long call option works
If you believe a certain stock is going to go up in price in the coming days, weeks, or months, you can purchase a long call option to buy that stock for today’s price sometime in the future and make a profit by selling it on the stock market at the then- higher price.
Example: You believe ABC stock, selling today for $100 a share is going to be worth more in a couple of months. You purchase a long call option contract for 100 shares, set to expire in three months, at a strike price (a preset price) of $100 per share, and a premium (fee) of $3 per share for the option itself.
ABC does as you expect and in two months shares are worth $150 apiece. You exercise your option, buy 100 shares at $100 each, sell them for $150 each, and you’ve made a tidy profit of $4,700.
How a long put option works
If you believe a company’s stock is due for a drop, you would purchase a long put option contract giving you the right to sell shares of that stock in the future for today’s (higher) price.
Example: You believe ABC is going to decline in a couple of months. You purchase a long put option contract for 100 shares, set to expire in three months, with a strike price of $100 per share, and a premium of $3 per share.
ABC does as you expected and in two months shares are selling for $50. You buy 100 shares at $50 each, exercise your option, and sell them for $100 each, and you’ve made a tidy profit of $4,700.
Exercising your long call or long put option
Whether you buy a long call or a long put, you can’t make money unless you exercise your option. Exercising your option means to buy or sell before the expiration date set in the option contract.
Naturally, you’d exercise the option if things go the way you expect – the stock moves in the manner you thought it would, so you get to buy it (with a call) or sell it (with a put) at a price that’s better than the current market rate.
Why would you let the option expire without exercising it? Simple: The price of the stock goes against your prediction, moving in an opposite direction from the strike price. If that happens, the option becomes worthless. You let it expire, and you lose the premium you paid.
The good news is, that’s all you lose.
Why take a long position in options?
Going long lets you take chances with less risk. Both long calls and long puts limit your loss to the premium, the cost of the options contract. You don’t have to buy the stock (in a call) or sell the stock (in a put) unless you expect to profit – by the shares moving as you anticipated before the contract ends.
In contrast, in regular investing, you’re committed to an actual purchase. And that could cause you to lose a lot of money if the stock doesn’t move in the direction you expected.
In addition to being less risky, long options also include an unlimited profit potential to the upside in the case of a long call option or the downside with a long put option. As long as the stock is above or below your option’s strike price – for the call or the put, respectively – you stand to win.
Both types of options are considered long, in the sense that both are buy positions and both let you make money on the direction of the underlying stock. However, the long call is the more bullish sentiment, because you’re betting that the stock price will rise.
The long put option is a more bearish view because you’re anticipating, and hoping to profit from, a fall in the stock price.
A long put option can also serve as a hedge, or insurance, against a bad outcome with a long call option or an outright purchase of stock. Yes, you’re betting against yourself, in a way, but at least you stand to benefit a bit if the stock falls instead of rises, mitigating your overall loss.
The financial takeaway
With options, going long refers to a position in which you buy:
a long call option, meaning that you expect the underlying asset to increase in price, which increases the value of the option. This option is bullish on both the underlying stock and the option itself.
a long put option, meaning you expect the underlying asset to decline in price, which increases the value of the put option. A long put option is bearish on the underlying stock but bullish on the outcome of the option.
Long option positions require less investment, or cash down, than outright investments. Instead of spending thousands on a stock, you just spend a few hundred on the option, giving you more leverage for less money.
Of the two options, long calls are more common – or at least, what’s more commonly thought of as a long options position. And, like buying stock outright, they are essentially optimistic. Long puts, pessimistic bets that a stock will fall, are more often used as insurance against a bad outcome with a long call, or with an actual ownership position.
But in a way, both long options can be considered bullish: Both are buy positions, affording you a chance to make money on the moves of the underlying stock.
One Robinhood user in Massachusetts made an eye-popping 12,748 trades since February, according to the state’s complaint, which alleges the popular investing app encouraged inexperienced investors to execute trades frequently.
The complaint against Robinhood was filed on Wednesday and also detailed how the brokerage firm popular among younger investors failed to supervise the review and approval of options tradings, leading to many inexperienced traders dabbling in more complex investments.
In an e-mailed statement, Robinhood said, “We disagree with the allegations in the complaint by the Massachusetts Securities Division and intend to defend the company vigorously.”
Robinhood’s rapid growth and lack of internal controls facilitated an environment where inexperienced investors would trade stocks and options incessantly, nearly 100 times per day on average in one case, the state of Massachusetts said in a complaint filed on Wednesday.
The complaint is separate from a settlement with the Securities and Exchange Commission announced on Thursday that resulted in Robinhood paying $65 million to settle charges of misleading clients on the quality of its trading service.
According to Massachusetts, Robinhood successfully encouraged inexperienced investors to execute trades frequently on its platform by utilizing gamification techniques.
“During the relevant time period, at least 241 Robinhood customers with no investment experience averaged at least 5 trades per day on Robinhood’s platform,” the complaint said.
An average of five trades per day is peanuts relative to 25 Massachusetts Robinhood customers detailed in the complaint.
“Robinhood experienced as many as seventy outages or disruptions on its trading platform from January 1, 2020 through November 30, 2020 as a result of its failures,” the complaint said. At least seven of those disruptions impacted the ability of Robinhood customers to access their accounts to buy or sell securities.
Four more allegations against Robinhood listed in the complaint include: advertising to younger individuals with little to no investment experience, providing lists to encourage customers to purchase securities without consideration for suitability, employing a number of strategies to encourage customers to continuously engage with its application, and failing to meet the fiduciary duty it owes its customers.
In an e-mailed statement, Robinhood said:
“We disagree with the allegations in the complaint by the Massachusetts Securities Division and intend to defend the company vigorously. Robinhood is a self-directed broker-dealer and we do not make investment recommendations. Over the past several months, we’ve worked diligently to ensure our systems scale and are available when people need them. We’ve also made significant improvements to our options offering, adding safeguards and enhanced educational materials. Millions of people have made their first investments through Robinhood, and we remain continuously focused on serving them.”
Robinhood is likely hoping for a swift resolution to the complaint as it plans to go public next year at a valuation of more than $20 billion, according to reports.