The recent tech rally has been nothing short of extraordinary with many stocks reaching all-time highs, but what has caused this impressive growth? The answer is SoftBank. The “Nasdaq Whale” that is SoftBank has been causing a stir in the investment world by buying billions of dollars’ worth of U.S. equity derivatives in the form of options, specifically call options. Its big bet has not only helped the tech sector recover, but has also made the tech group a handsome profit.
So what are options?
Before getting into the details, we will be covering options in an Investing 101 article in the next couple of weeks. However, for now, it is important to know that options are contracts that give the holder the right, but not the obligation, to buy or sell a stock at a set price within a set timeframe. There are two types of options - call options and put options. Call options allow the buyer to make a profit on stocks that are going up in value and put options allow the buyer to make a profit on stocks that are falling in value.
Options offer unlimited upside, but very little downside compared to normal stocks. This is because options contracts are a lot cheaper than buying the stock of the company itself. Therefore, an investor is risking less of their capital, but can still gain just as much. However, options contracts are much more volatile than stocks and so can be seen as quite a risky bet, which is how many people viewed Softbank’s operations.
SoftBank’s big bet
SoftBank’s founder Masayoshi Son manages and invests $100 billion dollars for the tech group and has a very high-risk investment strategy which paid off recently, gaining profits of around $4 billion. He has taken big bets on the major tech stocks like Microsoft and Amazon.
This is new territory for SoftBank, who’s investment model has been centred around a high-risk-high -reward strategy, but previously put these risks towards technology start-ups. However, coronavirus hit these start-up investments heavily, and so SoftBank turned to options trading.
The purchases by SoftBank have fuelled the largest ever volume of options contracts linked to individual companies. With these new limits reached, it is unprecedented territory for options trading, and many view Masayoshi’s bets as “dangerous.” In truth, some believe that his actions are effectively turning the tech group into more of a hedge fund.
The surge in call options interest is not just from SoftBank, but also from retail customers, which has caused the stock prices for these tech giants to skyrocket, fuelling the recent rally. The value of trades involving ten or less call options has increased to $40 billion this year, compared to just $5 billion last year.
Why is the high volume of options being traded causing the stock market to rally? Well, when someone wants to buy a call option above the current price, they have the expectation that the price is going to rise even further. The seller of the call option will often buy the stock itself to act almost as insurance for if the stock does in fact rise. This increased demand for the stock will therefore drive the price of the stock up, stemming from the increased interest in call options.
This has created a feedback loop or vicious circle, in which the rising stock price leads to more call option buying, leading to more sellers hedging themselves by buying the stock, which once again raises the price.
However, this is leading to a very volatile market, because, whilst some buyers are purchasing call options expecting the trend to continue, others are betting against these tech stocks and buying put options in the expectation that the rally won’t continue. This is what we have seen in the last week, with tech stocks being pulled back (their share prices falling). The put options are trying to pull the stock the other way, and so, with this high volume of call and put options being traded, it creates a very explosive market, with volatility the highest it has been in years.
The Nasdaq volatility index supports the theory of rising volatility in the markets, especially with tech stocks. The recent pullback has hit many investors like SoftBank, and, from now on, I think the volatile nature of the market will make investors act with more caution before placing large bets on options trading.
SoftBank’s investment strategy, that is heavily focused on options contracts, has been supported by the rise in engagement from retail investors in options. This has ushered in a climate of unpredictable market conditions. September saw the market start to fight back against the tech rally, with the biggest tech stocks all having sharp pullbacks - Apple stock has fallen some 20 per cent in the last weeks, and Amazon has also decreased by about fifteen per cent.
With the threat of another surge in coronavirus cases and imminent lockdown measures, the market may continue to cower, and we could see this pullback turn into another bear market dip. However, the tech stocks showed amazing resilience after the pullback in March and so this may just be a temporary dip to consolidate further growth in the stocks.
Whichever way the market goes, this should be a warning to retail investors who have enjoyed the fruits of the recent rally but may struggle in the treacherous times of a bear market if the current pullback were to continue.
Even SoftBank has had to re-evaluate its strategy after the recent pullback has cut into its profits. The firm has told investors that a shift to less risky options position is likely, but was also quick to assure investors that the current investment stance remains relatively conservative. The current investments have an emphasis on call spreads rather than highly leveraged short-term bets. A call spread is less risky, as a trader sells a call option whilst buying another one at a lower strike price, in order to limit their potential loss. However, it also limits one’s potential gains.
SoftBank has popularised trading in options contracts recently, which has seen retail interest boom. They have shed a light on an alternative investment strategy, which, when applied correctly, can result in impressive results as SoftBank has shown.
The glitz and glamour of a bull market has given SoftBank these impressive results, but the flip side of a bear market, which could soon be upon us, could reveal weaknesses in Masayoshi Son’s strategy.
SoftBank’s stock fell around thirteen per cent at the beginning of September as the pullback threatened its call options-based strategy. So, it will be interesting to see which way the market goes and whether SoftBank will be able to continue building upon its impressive profits.