The Nope theory to explain volatility in equity markets

In recent months the stock market has been, to use a technical term, weird. This is down to more than the usual bumptious volatility of a bull market top.

The markets have been punctuated by wild jumps and crashes in unlikely names, from junk stocks such as GameStop to established companies such as ViacomCBS, after it was drawn into the Archegos debacle. 

One factor in many of the strangest market episodes is the shadow cast by the equity options market. 

Equity option taking volumes have surged in recent years. According to the NYSE, the average daily volume of trading in option contracts on equities and exchange traded funds went from 17.5m in 2019 to 27.7m in 2020. This year the market is on pace for more than 40m contracts.

This matters to those who still trade in the boring old plain-vanilla stock market because all those options to buy and sell shares have to be hedged by the dealers which offer them.

When options-related volume is a significant portion of the market, this makes the market unstable.

For “call” options to buy stocks, dealers often do this by buying the underlying shares. In the jargon, the amount of shares a dealer has to buy to hedge an option is the option’s “delta”. The delta depends on how likely the stock is to hit the strike price of the option, and the option’s expiration date. 

Here’s the tricky part. The delta of an option changes with the price of the underlying stock. So if a stock really starts to run up, dealers of options in it have to buy more of it to hedge the options they have sold. This adds to the upwards price pressure, driving the shares up further and forcing the dealers to buy yet more shares, which in turn . . . well, you see where this is going. This kind of snowball was behind the more violent spikes in GameStop, a name retail option buyers piled into heavily.

The punchline is that the state of the equity options market at any given moment tells you something about pressures that will be subsequently felt in the equity market itself — and it should be possible to trade on this fact. 

The rather unlikely standard bearer for this sort of trade is Lily Francus, a twenty-something PhD student in bioinformatics. Until recently, she was an amateur trader, but her funny and lucid social media and blog posts have won her a media presence, and she is now trading for a living.

Francus’ core concept is an indicator called Nope — the “net options pricing effect” — which is a rough-and-ready (or as she says, “hand-wavey”) gauge of the weight the options market is exerting on the stock market. It estimates the amount of the liquidity available in a certain stock or index that is being sopped up by options dealers’ hedging (it is only an estimate, because dealers have other ways to hedge than buying the shares). It calculated as the delta of all the outstanding “call” options to buy stocks, less the delta of all the “put” options to sell them, divided by the total daily volume trading of the shares. 

When Nope gets unusually high, Francus says, “the market has a strong tendency to reverse”. Her explanation is that as a stock moves fast and options dealers pile in to make sure they are hedged, this pushes the rally to extremes. But when the rally finally exhausts itself, the options dealers quit buying all at once, and the market quickly reverts to the mean.

“When options-related volume is a significant portion of the market, this makes the market unstable,” she sums up. Keeping an eye on Nope can, in theory, help you pick which rallies to sell (it seems to work for routs too, but not as reliably).

This volatility-encouraging character of options is a nice iteration of a familiar Wall Street irony: a financial instrument designed to manage risk is turned into a speculative device, making the market riskier. Credit default and total returns swaps are two other good examples. 

The rise in options volume and Nope levels in recent years also demonstrates the protean nature of risk. When it is suppressed in one area, it appears in another form somewhere else.

Francus points out that “Nope-related behaviour” in the market took off in 2018, after Credit Suisse shut down its huge XIV fund, which offered a way for traders to bet on market volatility. The fund was crushed in a market rout early that year, known as “Volmageddon.” But the traders just turned to the traditional, highly leveraged way to trade market volatility: the equity options market.

With Nope, Francus has crystallised a concept that may give us a deeper understanding of market volatility. But the appetite for dangerous levels of risk, especially in bull markets, will persist. 

robert.armstrong@ft.com