The U.S. equity markets remain close to all-time highs as money continues to pour into equities despite higher valuations than ever. Some metrics of these markets are simply out of this world – and yet, investors keep bidding at such prices.
There is always an excuse to buy into the shares of a company. The traditional analysis involves discounting the future cash flows to reach the true intrinsic value of a company. However, this approach belongs to finance 101, something that in the2020 pandemic year simply will not function.
When investing in the stock market, one should consider two risks – macro and micro. The micro one refers to the risk that the company will stop being a going concern. In other words, by interpreting financial statements, one aims at diversifying away from the micro risk. On the macro level, however, it becomes a bit more complicated due to exogenous factors that may drive general prices higher or lower. Think of the end of 2020 and what is on the table – Brexit, EU budget, transition of power in the United States, to name a few.
Using Options to Trade
Options are derivatives. They are contracts that give a trader the right, but not the obligation, to buy or sell the underlying asset when the contract expires.
The basic principles underlying options trading is very simple – when buying a call option, the trader benefits if the price of the underlying asset rises. When buying put options, the trader expects the market to decline.
Imagine that you are bullish on the stock market. That, despite all the strong performance in the year, you still believe that the market has room to go. However, being afraid of the macro risks mentioned earlier, or some other ones, you want to protect the investment. One possibility is to buy put options.
In doing so, in the eventuality that the market declines, the put options will end up winning and thus reduce the potential loss. On the other hand, if the market is higher when the put options expire, the trader stands to lose the price paid for the option but win on the general stock market portfolio.
Again, this is a basic strategy used, but options trading is a complex subject. At this point, small options traders are setting bullish records on the market. This is calculated by deducting the net short positions (sell calls plus buy puts) from the net long positions (buy calls plus sell puts).
If the result is positive, the market is long or bullish. The bigger the difference, the more stretched the market is. At this time, the net long positioning reached record highs.