A Strong Indicator That the Market Has Caught Speculation Fever
Signs that we reach a speculative fever
The rally from the March lows has surprised even the most optimistic bulls. Most market prognosticators are expecting the gains to continue in 2021. But, there appear to be signs that we’re reaching a speculative fever, which is due for a break.
The S&P 500 (SPY) is up 66% and the Nasdaq (QQQ) has surged 82% since bottoming in March, while dozens of individual stocks, Tesla (TSLA) being the poster child, have gained 200% or more.
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The new generation of active traders’ storyline is well documented. Retail traders now account for over 20% of trading volume — up from a 10-year average of just 8%.
Impeccable timing with their entry coinciding with the market low with many enjoying huge profits which created unrealistic expectations. This led many investors to take on more risk in hopes of even bigger gains. This can expose both the individuals and the market to large losses. People are also borrowing against their investment portfolios, pushing margin balances to the first record in more than two years, to buy even more stock. Investors using margin debt pledge their securities in exchange for loans from brokerage firms to make further investments. They can get into trouble if their collateral falls below a certain threshold, triggering a margin call. They then have the option of either putting up more money or selling the securities underlying the loans.
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This is a strong indicator that stock-market euphoria flashed red last month. Investors borrowed a record $722.1 billion against their investment portfolios through December, topping the previous high of $668.9 billion from May 2018. The milestone is an ominous one for the stock market as margin debt records tend to precede bouts of volatility, as seen in 2000 and 2008.
Indeed, Monday’s relatively modest decline of 1.8% in SPY caused the VIX or volatility index to jump 26% to a two-month high of 28%. This quick pop indicates, despite the consensus bullishness, that there’s underlying nervousness with many people being quick to head for exits if there is a sense that the rally’s sputtering out.
Options trading exploded in 2020
People are also piling into more exotic products such as options and leveraged exchange-traded funds which they may not fully understand the risk. Options trading exploded in 2020 as individual investors flocked to the stock market. A record number of options contracts have traded this past year. An average of 29 million changed hands each day this year, a 48% jump from 2019. And people are increasingly using the above-mentioned margin debt to finance options trade, creating a situation where one can incur losses in excess of their account size. Again, the danger isn’t just to the individual but makes the overall market increasingly fragile.
Zoom decline 40% over the past three months
There are some signs that the air is coming out of certain pockets. For example, Zoom (ZM) declining 40% over the past three months after surging 400% from March through October, exposing people who bought near the high, thinking stocks only go up to real pain. The market may have another thrust higher. However, I fear we’re reaching a speculative fever that’ll need to break, ultimately leading to a healthier investing environment.
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