Economist El-Erian says derivatives show retail traders may be drowned by a large correction in stocks

MOHAMMED EL ERIAN2.JPGReuters/Phil McCarten

  • Mohamed El-Erian said in an op-ed in the Financial Times that the boom in retail trading may slow down as the options market is signalling a correction. 
  • Investors have piled into call options in the recent weeks, instead of long equity positions “due to the fear of missing out,” he said. 
  • Stocks have rallied sharply in recent months, the S&P 500 and Nasdaq both hit all-time highs on Monday.
  • He said: “The seemingly endless rally in US stocks gives the impression that prices are endorsed and supported by the entire professional investment community.”
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Mohamed El-Erian said in an op-ed with the Financial Times retail investors should consider the outlook of the options market to prepare for a stock market correction following explosive gains over the last five months. 

The chief economic advisor of Allianz said Monday: “The seemingly endless rally in US stocks gives the impression that prices are endorsed and supported by the entire professional investment community.”

He added: “After all, despite the vocal concerns over valuations having split away from underlying corporate and economic fundamentals, few fund managers have been willing to challenge the market by placing outright shorts.”

El-Erian’s comments come as short bets against US stocks have fallen to their lowest levels in the last 15 years, according to data from Goldman Sachs. 

“The fear of missing out on an unceasing equity rally has increasingly been expressed through call options,” he said. 

In contrast to equity longs, call options gives the buyer the right to buy the underlying asset at a predetermined price on a certain date. Buying calls suggests an investor believes an asset has further room to rally.

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“[A call] limits the amount at risk and gives users the ability to capture rallies. It has been supplemented by more downside ‘tail protection’ aimed at safeguarding portfolios from sharp drops,” El-Erian said. 

“The Vix volatility index has decoupled from equity indices, adding to signals that a large market correction, should one materialise, would encourage more professional selling that could overwhelm the buy-the-dip retail investor,” he added.

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Stocks have been very volatile in recent months. After touching coronavirus lows of 2237.40, the S&P 500 has fully erased its 2020 losses and hit a record above 3,514 points on Monday. This means the index has recovered 53% from its March lows.

The Nasdaq also hit an all-time high on Monday, fueled by a recent rally in tech stocks, particularly the likes of titans Tesla and Apple

A number of factors has contributed to the strength in the equity markets. Central banks have rolled out stimulus relief packages worth billions of dollars to help the economy ride out the pandemic. This has caused rates to fall, making equities an attractive place to invest money. 

A number of amateur retail traders have since piled into anything from big blue-chip stocks, to those of bankrupt car rental company Hertz, as well as into several other near-worthless stocks such as retailer JCPenney. This comes as a frenzy of day-trading flooded equity markets in recent months, with amateurs seeking to profit from a swathe of stock-price crashes in the wake of the coronavirus crisis.

El-Erian said a sharp economic downturn resulting from a “considerable monetary or fiscal policy mistake” or market defaults would increase the likelihood of “further market turmoil..especially given the current lack of a short base to buffer the downturn.”

He concluded: “This exposes small retail investors to big potential losses. It risks broader economic damage and could end up pulling central banks even deeper into distorting price signals and undermining the markets’ role in efficiently allocating resources throughout the economy.”

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