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Most traders assume that options follow the price of the underlying stock.
So if the stock price rises, its call options will typically increase in value. And if it falls, its put options will typically rise in value. That’s why options are known as “derivatives” – their value is derived from another asset.
But sometimes that relationship can start working the other way around.
When enough money starts flooding into short-dated options, the resulting activity can start to influence the underlying stock itself. Call option buying can help drive the stock higher, which in turn can attract more option buyers into the trade.
It’s a feedback loop that can produce sharp moves in an extremely short period. But when that feedback loop breaks, the reversal can be just as sudden.
That’s why traders need to understand what’s driving a move before deciding to jump on board.
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We’ve seen it a lot – especially throughout the AI boom. Suddenly, a stock becomes popular after releasing some positive news.
But rather than buying the shares outright, many traders buy call options. That can become even more prevalent when stocks are trading in the high hundreds or even over $1,000.
Calls enable traders to gain exposure to a stock for a fraction of what buying the shares would cost. That leverage can generate substantial percentage gains when the stock moves in the desired direction.
However, someone must take the other side of every option trade. That role is often filled by a professional market maker.
Market makers provide liquidity so that traders can buy and sell options when they wish. Those market makers don’t want to take a big directional bet on where the stock is going.
Say they sell a large batch of call options. If those get exercised, they’re on the hook to hand over the stock. So to cut that risk, they may buy some of the underlying shares. If the stock keeps climbing, they may need to buy even more shares to keep their position hedged.
And that’s where the feedback loop can take hold.
Traders buy call options. Market makers buy shares to hedge some of that exposure. That helps drive the stock price higher, encouraging even more call option buyers to enter the market.
It can become a case of the tail wagging the dog, so to speak. Before long, the options aren’t simply responding to the stock. Instead, option-related activity may also be helping propel the stock higher.
To be clear, it doesn’t mean every surge in call option buying will produce the same result. Market makers may have other positions to offset that exposure.
But when trading becomes heavily concentrated in the same short-dated options, hedging flows can really amplify a move.
The problem comes when traders mistake that mechanically driven demand for a genuine improvement in the company’s prospects.
They see the stock accelerating and assume that a new uptrend has begun. And these days, everyone’s connected – social media, trading sites, chat rooms. So the initial move can set off another wave of buying as traders fear missing out (FOMO).
But eventually, that flow begins to dry up.
Early traders start taking profits. New buyers become reluctant to pay inflated premiums. And with time decay accelerating as expiration approaches, those short-dated contracts can quickly lose much of their remaining value.
When that happens, market makers may no longer need all the shares they bought as hedges. As they reduce those positions, that buying support can quickly disappear and even turn into net selling.
Option buyers late to the move can see the value of their options collapse right in front of their eyes.
That doesn’t mean these moves can’t be traded – far from it. Option-driven momentum can be very real – and potentially highly profitable to trade. But you don’t want to confuse a short-term feedback loop with genuine, sustainable investor demand.
That’s why I watch for a few warning signs: heavy or unusual activity in short-dated options, premiums rising fast, or big volume piling up around certain strike prices. I’m also wary if a stock’s move appears completely out of proportion to the associated news.
Options can create tremendous trading opportunities. But once option activity starts moving the stock, traders need to understand that any move could be short-lived — and fade as fast as it arrived.
Happy Trading,
Larry Benedict
Editor, Trading With Larry Benedict
Reading Trading With Larry Benedict will allow you to take a look into the mind of one of the market’s greatest traders. You’ll be able to recognize and take advantage of trends in the market in no time.
