Wall Street is increasingly uneasy about options-driven momentum trading that has helped push the S&P 500 index to record highs.
As demand for bullish call options rises to its highest level in years, some analysts have weighed in on Nvidia Corp.'s NVDA earnings report. on Wednesday and warn that this could be the trigger that potentially puts the brakes on this trade. This has wiped out a significant part of the market rally of the last four months.
Their argument is based on the fact that investors are so excited about risky options bets that the mere fact that the earnings report was passed could be enough to send major U.S. stock market indices lower due to the internal dynamics of the options market Nvidia's results are in line with Wall Street's expectations, according to several derivatives market experts who spoke to MarketWatch.
According to FactSet, analysts expect Nvidia to report earnings per share of $4.59, up more than 700% from the year-ago quarter.
See: Nvidia could shine again when it reports on Wednesday
Traders have been piling into bullish options at a rapid pace since 2021's meme stock frenzy
As stocks staged a rally last year that surprised many on Wall Street, investors increasingly relied on options to drive the market higher and boost returns.
This has pushed demand for bullish out-of-the-money calls on the biggest U.S. stocks to the most distorted level since the meme stock boom, according to data from Cboe Global Markets, one of the largest options exchange operators in 2021.
An option is traded “out of the money” if the option's strike price is above the price of the underlying stock or index in the case of calls, or below the price of the underlying stock or index in the case of puts.
In the options market, “skew” typically measures the demand for out-of-the-money calls versus out-of-the-money puts, or the demand for out-of-the-money puts or calls versus their at- the monetary counterparts. In this case it is the former.
A key difference between the meme stock era and the recent turmoil in the options market is that this time there are more stocks being traded that are heavily weighted in major market indexes, said Michael Lebowitz, portfolio manager at RIA Advisors.
“Option buyers are usually more insurance buyers. But now they’re more speculative traders, that’s what the skew tells you,” he said during an interview with MarketWatch.
Michael Kramer, a longtime independent stock market analyst and founder of Mott Capital, said Nvidia's profits could be crucial to the market, but the odds are stacked against the chipmaker.
“In my opinion, the market made a gigantic bet on a company,” Kramer said. “If Nvidia doesn’t go up significantly, what’s going to keep things going up?”
With the stock already up nearly 50% this year, Nvidia has contributed about 25% to the S&P 500's 4.9% rise since the start of 2024, Kramer said.
Nvidia's skew hit its highest level since June on Thursday, according to data from SpotGamma, which provides data and analysis on the derivatives market.
Kramer said most of the stock's rise in recent months has come from aggressive call buying, which has forced options marketmakers to buy up shares of the underlying stock to hedge their positions.
The rally is likely to reverse after Nvidia results
While Nvidia has become the poster child of momentum trading, numerous other stocks have joined in. That's why Brent Kochuba, founder of SpotGamma, believes the broader market could decline alongside Nvidia next week, as bullish call options tied to a number of large U.S. companies are likely to become cheaper after the chipmaker reports earnings has given.
Once Nvidia's earnings report is released, implied volatility in the options market should decline, Kochuba said. This would be a typical reaction: implied volatility increases when investors see potentially market-moving events that they want to hedge against or speculate on. The opposite often happens when these events pass the market by.
As implied volatility falls, the options would become cheaper, while at the same time the market makers who sold them would have the opportunity to sell off some of the shares they had accumulated to hedge their positions.
“Anything with a strong call skew could see a little more selling pressure” after Nvidia reported on Wednesday, Kochuba said in a note to clients shared with MarketWatch.
Options marketmakers typically buy stocks or index futures to hedge their positions because if an option goes in-the-money, they could be forced to deliver on the underlying stock.
Many other technology companies are also experiencing extreme skew in call options, particularly semiconductor companies such as Advanced Micro Devices Inc., AMD and Arm Holdings ARM, as well as other Big Tech giants such as Microsoft Corp. MSFT as traders bet Nvidia rises The tide could boost the entire information technology sector.
Many on Wall Street, including Kramer, have been unhappy with the role the options market has played in driving the broader market higher since October, particularly as investors have raised expectations for the number of interest rate cuts by the Federal Reserve This year, while earnings outside of some mega-cap tech companies were generally weak, Kramer said.
The market's rapid rise has left stocks trading at their highest levels relative to their expected earnings in more than two years, as major stock indexes such as the S&P 500 and the Nasdaq-100 pushed into record territory during the Wall Street analysts have weakened expectations for corporate earnings growth in 2024.
The S&P 500's ratio to its expected full-year profit recently topped 20 for the first time since the start of 2022, above its five- and 10-year averages, according to FactSet data.
The forward price-to-earnings ratio for the Nasdaq-100 NDX is even higher, at over 26 on Friday.
“Stocks don’t trade on earnings momentum. They trade on multiple expansion,” Mott Capital’s Kramer said.
Momentum creates momentum
Of course, just because momentum has helped push stock prices higher doesn't mean traders can easily make a profit by betting that momentum will soon reverse. As is often the case on Wall Street, momentum typically breeds momentum.
“The pace of these rallies isn't really sustainable — and in the case of something like Nvidia, it sets a pretty high bar for the profit hurdle — but timing when the momentum starts to fade is always the tricky part,” said Bret Kenwell, investment analyst for US options at eToro.
US stocks ended the week's final trading session in the red, with the S&P 500 SPX and Nasdaq Composite COMP ending their five-week winning streak. The Dow Jones Industrial Average DJIA, on the other hand, managed to extend its winning streak to the sixth week in a row.
Aside from Nvidia's earnings, the calendar of potential market-moving events for next week looks pretty thin, aside from the release of minutes from the Fed's January meeting.