Options Trading Surges Amid Rising Rates and Tech Stock Declines

Investors are trying to take advantage of higher interest rates and the recent drop in value of big technology stocks by buying options. This activity is driving up prices in the options market.

Some popular stocks include Amazon.com Inc. and Nvidia Corp. NVDA 4.16%.

The value of some options tied to shares that have lost half their value in the past year has risen, as the shares have declined much more steeply than many investors expected, creating a large number of deep in-the-money put option contracts.

Nvidia shares closed Friday at $148.59. However, there are tens of thousands of put option contracts set to expire in the coming weeks that could be exercised at $170 or above.

Many traders are selling contracts and reinvesting the premium in short-term investments such as repurchase agreements. These agreements now offer their most attractive yields in more than a decade.

According to an analysis of Options Clearing Corp. data by derivatives-analytics firm SpotGamma, the trades helped push the weekly amount spent on new put option purchases and sales above $40 billion four times in the fourth quarter. That compares with a weekly average of less than $10 billion through the first three quarters of 2022.

Put options give traders the right to sell shares at a stated price by a certain date, while call options grant the right to buy.

Brent Kochuba, founder of SpotGamma, describes the trade as an "arbitrage play" among big Wall Street firms. Activity in the trade gained steam in the latter half of 2022, during which the Federal Reserve increased its benchmark interest rate to above 4% from below 2%.

"The recent sell-off in megacap tech stocks has created an opportunity to buy put options that are now deep in the money," he said. "Once interest rates surged, market makers piled in."

Although the amount of money that traders spent on options soared, the number of contracts traded rose by less than one-fifth. This suggests that expensive puts, such as those that are deep in the money, were the ones changing hands.

The options market has seen significant growth in recent years, driven in part by individual investors who are attracted by the low initial investment and potential for quick profits. Trading activity hit a new record last year, with an average of over 41 million contracts traded each day.

Short-dated options that allow traders to make bigger bets have become more popular recently. Trading of deep in-the-money contracts more than doubled to nearly 11% of daily average stock-options volume in the fourth quarter, according to Henry Schwartz, senior director and head of product intelligence at the exchange Cboe Global Markets.

Options trading is risky. Investors typically buy options to bet on the direction of a stock or index for a fraction of the cost of buying the security outright. The risk of selling is greater, and a trader could be liable for several times the initial cash they receive.

The recent surge in put options activity carries a different kind of risk. Traders who buy deep in-the-money puts may have to pay a higher upfront cost, but they hope they won't have to buy shares at a higher price if the bank or party on the other side of the trade exercises the options.

"Firms have different objectives and trade different structures with slightly different exposures, but they're all going after the in-the-money puts," said John Zhu, U.S. head of trading at market maker Optiver in Chicago.

Mr. Zhu noted that some traders might be looking to reduce existing exposures, rather than add new ones.

The recent boom in activity has led to a change in the ratio of equity put options to call options traded on Cboe. This ratio is traditionally seen as a measure of investor anxiety, and it recently rose to 2.4 after breaching 1.5 for the first time ever in December, according to Dow Jones Market Data.

Despite the appearance of fear in the markets, other indicators suggest that options protecting against market turmoil are in low demand. The Nations TailDex, which measures the cost of put options that would pay out in a major S&P 500 decline, recently hit a near-decade low. This suggests that investors are not overly concerned about the possibility of a major market decline in the near future.

"Many people believe that high readings in the Cboe equity put-call ratio indicate that fear is widespread, because traders are buying a lot of puts," Mr. Kochuba of SpotGamma said. "Sometimes this is true. But in this case, it isn't."