Have you ever stopped to wonder why everyone rushes into the market only when stocks are going up? For decades, investors have had the option to make money in bear markets as well as bull markets. Where was the put option boom of 2008 or the inflow into 3x reverse ETF’s? Certainly this was going on to some extent, it just wasn’t a tool of retail investors. My theory is people just like the color green. Making money off of prices going up just seems to make more intuitive sense. It’s like we all win, as opposed to shorting stocks or buying puts, where the sentiment is that you are profiting from someone’s misery. Short sellers and naked put purchasers rank right up there with most despised professions. But puts offer insurance which many are willing to pay for and shorting helps prices reach efficient values. It’s the constant death and rebirth of the market that allocates capital to where it offers the highest returns.

Lately retail traders have been doing their part to assist in this allocation. Investing through Tik Tok tutorials is becoming a real thing. The r/wallsreetbets subreddit is now the second most popular subreddit on the site. If you have spent any time on r/wallstbets you may think that everyone is selling to “greater fools” to get out of their risky options but you may be mistaken.

Institutional investors and hedge funds seem to have developed an ever growing side business selling these options to retail traders. The logic as to why is pretty simple, options are the right to buy a share at a price called the strike price. Options also contain an expiration date. If the price of the underlying stock does not rise above the strike price before the expiration date, the option expires worthless. If the price rises above the strike price, the owner can either sell to someone else before expiration or exercise their right to purchase the underlying shares at the strike price at expiration. So why would anyone ever be the writer (i.e the original seller) of an option and give up the gains to a retail gambler? The answer is that it’s a profitable business for long only funds that hold the underlying stock.

Retail traders love the cheap bets that payoff big. Out of the money options refer to those options that are far off from the strike price. These tend to be cheap. Even cheaper are those far off the strike price and close to expiration. For example, Tesla which is currently trading around $845 a share has call options which expire on February 5th with a strike price of $1,120 selling for $2.65. An options contract represents 100 underlying shares (1 lot, as the terminology goes) so the price you see is always multiplied by 100 to arrive at the cost to acquire one contract. In the example I gave, one contract cost would be $265. Tesla would have to rise 32.5% in the next 2 weeks for the contract not be worthless at expiration. If there were a big earnings surprise however, even if it never reaches that price, speculation will grow that it could go up even more. When this happens, those long shot bets explode. These are often the trades you see of people turning $700 into $14,000.

Many have maligned this retail boom much as commentators did in the late 90’s with the day trading frenzy. Indeed we are seeing many of the same things repeat themselves. This couple featured on Bloomberg, which made a Tik Tok that went viral with 1.8 million views, claimed to have quit their jobs to trade full time. Trading has been combined with the early retirement movement to enable people to “do what they want” and enjoy tons of free time by making a few trades a day. The couple utilize a technique known as “scalping” where they quickly jump into and out of shares. The male half of the pair, Chad has started his own Tik Tok called @crappywallstadvice where he simply outlays what he does in the plainest language possible. He may invest in actual shares but he freely admits that most of his trading is in options. He does little to no research on the companies he invests in and often doesn’t even know what they do. But Chad admits he’s no expert, he’s simply following trends in what’s known as momentum trading. The fact that so many retail traders have moved into this market has bumped up liquidity and made those options on popular shares like Tesla and Apple easier to get rid of. This is the other side of the bet, the liquidity that the market is now offering gives a quick and easy out which facilitates day trading.

The Options for Making Money

So if you want to jump into this trend, there are a few different ways.

• Buy Options – This is the first and most obvious way and the way in which most investors are jumping in. Even institutional trading firms like Susquehanna and Citadel freely admit that they are monitoring r/wallstreetbets to be able to predict retail movements. Volatility is your friend with options so buying deep out of the money options is one way to gamble. Most retail investors never exercise the option to purchase the underlying stock, they simply trade away their options whenever they see a price rise.
• Sell Options – This is also known as writing calls. If you are a long term investor that has large positions in single stocks, writing options has always been a tactic to add some income to your return. When I spoke about the institutional investors that are happy to facilitate this boom by writing calls this is what I meant. These institutional investors have large positions in a number of the most popular stocks. They can enhance their income by writing calls and collecting the premium. This strategy is characterized as having consistent and constant income with an occasional blow up that would force you to sell some of your underlying shares if your call goes the wrong way and the buyer wants to exercise their right to purchase at the strike price. Investors can protect against this scenario by creating a collar. In this strategy you write a call option and buy a put on the underlying stock owned. This tends to be used when the investor wants to lock in long term gains but make premium income in the short term.
• Capture Volatility- If you don’t know which way a stock is going or you think it could bounce around a particular price, then you could buy what is known as a long strangle. This strategy purchases a deep out of the money put option as well as a deep out of the money call option. If the underlying stock makes a big swing in either direction, the buyer makes money. The payoff chart to such a strategy can be seen below.

These are just a few choices you have to get started in writing or trading options. There are a number of combinations that utilize buying and writing both calls and puts as well as holding the underlying stock. In a future post, I will give an overview of these different strategies and how they pay off.

This Time is Better

What is different in the current retail frenzy compared to previous ones though is the honesty. There is much more entertainment in the chatter around the market than there was in previous booms. Traders freely admit that they know little to nothing about investing and that they are gambling their money. They often poke fun at themselves calling themselves idiots. The Wallstreetbets community members refer to themselves as “autists” a reference to suffering from autism. Traders share massive gains as well as huge losses via screenshots of their positions.

Rather than get caught op in the gambling trend, it may be also profitable to take advantage of the frenzy as a long term investor buy selling what people want: a gamble. Think of selling options on a stock you own like someone selling picks and shovels to gold miners in San Francisco in 1849: many won’t find anything but you can make a steady income from their greed. If you can’t resist the urge to gamble, I am a big fan of the core-satellite portfolio concept. This is where you keep 90% to 95% of your portfolio in a diversified portfolio of stocks, bonds, real estate etc and devote 5% to 10% to trend following gambling etc. Even the day traders have to learn about diversification the hard way. Chad, the Tik Tokker in the story above, even promotes diversification of your bets. On his page he relates his story of being all in on Kodak shares when they started to tank and he wasn’t able to quickly sell which nearly wiped him out. He now devotes only a portion of his portfolio to a particular bet.

Like anything however, long term investors know we are in a fad. What we don’t know is how long it will last. Don’t get distracted from your long term goals by Tik Tok day traders. When a correction or downturn happens, many of them will move on to different occupations and the next hustle. While they are here however, it couldn’t hurt to be humble, maybe even follow their strategies or at least be the other side of the trade for income. Embracing change is all part of the ride.

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