Friends, Canadians, fellow investors! Let me introduce you to Brandon Battle. He’s a 34-year-old amateur derivatives trader, and has been since last November. Before that, he studied information technology at college, served in the U.S. Air Force, and made his living buying trucks and leasing them to his cousin, who has a batch of delivery contracts with Amazon.com in Washington D.C., across the state line from Maryland, where Brandon lives and invests.
But then the pandemic and the lockdown happened, and Mr. Battle – like millions of other bored North Americans with extra savings or relief benefits – decided to buy some options on companies traded on the stock market. He taught himself how to do it on the internet.
No one predicted this. Even a decade ago, trading derivatives – complicated and risky, but potentially extra-rewarding, investment vehicles like options and futures – tended to be the exotic province of a small number of smart, professional, daring trader-lunatics. Only the brave and rich and brilliant went anywhere near them and lived to tell the tale.
These days, in the U.S. (and likely quite soon in Canada), thanks to deregulation and the rise of commission-free stock-trading apps on cellphones, neophytes such as Mr. Battle are happily gambling in the derivatives playpen, much to the dismay of some major players in the financial establishment. The now eight million barbarians on Reddit’s WallStreetBets site (that’s one in 40 Americans) have not only breached the gate of the mansion, as the GameStop brouhaha demonstrated last month, they’ve already moved in and are monopolizing the second-floor executive bathroom.
Mr. Battle is exactly the kind of amateur, unlicensed and potentially vulnerable individual investor – the famous “retail” client – Wall Street has often disdained, frequently taken advantage of, but these days can’t ignore. At this moment in financial history, Mr. Battle looks like the future.
At first, he bought only common shares in public companies, and promptly lost $2,300 (all amounts in U.S. dollars). “Basically, I was not really understanding what I was doing.” In November, he started practising his derivatives moves on Thinkorswim, an online trading platform for retail investors offered by U.S. broker TD Ameritrade. Two months later, he unloaded 20 options contracts in Marathon Digital Holdings stock, a blockchain-encryption company, and scored $8,000 on a $2,000 investment. “I didn’t get into GameStop,” he says, “because I didn’t believe the hype. It was just a little too unpredictable for me.”
He never consults a broker. Instead, he talks to 30 pals online in three different chat groups every morning, swapping ideas and strategies. Does he follow Warren Buffett’s advice and research companies that offer good value? He does not. “I honestly don’t do a lot of research,” he says. “I read the chart. Maybe this stock is trading between $12 and $14, back and forth in that range for about a week. As soon as that stock goes to like $14.50, I know that it has broken what’s called its upper resistance, and is likely to keep going up. And so that’s about when I buy a call option.”
A call option gives you the right to buy a stock at a fixed price. If that price is, say, $15 and the stock climbs beyond that, the value of the option rises even more, proportionately. And yes, Mr. Battle knows they can be risky. “In the second half of January, I actually lost $4,500. I got most of it back, about three grand, within the last three days,” he says.
Mr. Battle figures he’s on course to make $100,000 this year: “God willing. If you can make $500 a day in the market, you can make $100,000 a year.” He has already quadrupled his nest egg, to $12,000. “Over all, pretty good. I’m playing with the house’s money.”
So far – and that’s a serious caveat – Mr. Battle is living proof that the so-called democratization of the capital markets and the rise of the retail investor don’t have to end in tears, as so much of the business establishment is predicting. DIY derivatives trading is here to stay. The fact that Mr. Battle is also Black in a country where he says “there’s really a sick problem with racism,” makes his newfound participation in the roaring options market that much more auspicious and pleasing. He has decided to take his financial future into his own hands. After all, he says, defying a century of Wall Street catechism: “Options aren’t exactly rocket science.”
One could disagree. The history of finance is littered with catastrophes brought on by derivatives mania. Derivatives played a supporting role in the bursting of the $5-trillion dot-com bubble in 2002, and a leading one in the $1-trillion Flash Crash of 2010. And two derivatives even Wall Street didn’t understand – credit default swaps and collateralized debt obligations – helped usher in the Great Recession of 2008. Warren Buffett, the King of Careful Capitalism, didn’t call derivatives “financial weapons of mass destruction” for nothing.
Yes, trading derivatives is risky, but they also promise great gains, with very little money up front, thanks to the wonders of leverage. A speculator who buys an option or a futures contract isn’t buying the underlying asset (the actual shares, pork bellies or pesos); she’s just putting a little money down for an instrument she usually intends to sell before she has to shell out the full cost of the asset. A derivative, in other words, promises something for almost nothing, a great return for minimal outlay. Primal allure and seduction, brought to you by finance and physics.
Perhaps a brief example would help.
The simplest derivatives trade, the one that has seen almost unprecedented uptake since the pandemic started, is a call option. It almost sounds dainty.
Buying a call option gives you, the option buyer, the right (but not the obligation) to buy a stock, bond, commodity, currency or any other financial instrument, at a specified price within a specific future period.
Let’s say you’re very hot on ABC Corporation, an imaginary corporation. It’s Jan. 1, ABC’s stock is trading at $50 a share and you think it is going above $60.
If you don’t have a lot of money, instead of buying shares, you could buy ABC call options – the right to buy ABC shares. On Jan. 1, the price of a call option contract to buy ABC at $60 a share (a contract is always 100 shares), which expires on the third Friday in February, is $3 a share. The cost of your contract is therefore $300.
Unless the stock rises above $60 by its expiry date, your option is worthless. A recent study claims 70 per cent of options expire that way. You’re out $300.
But what if ABC stock rises to $70? The options contract increases proportionately more than the stock price, and is now worth at least $10, and more reasonably $12. Multiply your contract by 100 shares, and it is worth $1200. You sell the option, and collect a $900 profit on an investment of $300, a 300-per-cent return. That’s fantastic.
To have made a $900 profit on ABC stock without the leveraged option, you’d have to own 45 shares, which would have cost you $2,250: a 40-per-cent return on more than seven times the capital outlay. Perfectly acceptable as an investment return, but not as greedily satisfying.
In other words, options are terrific if you don’t have a lot of money and want to make a bigger return and they work out as planned.
But options can get incredibly complicated incredibly fast. You can option almost anything, from stock indexes to cryptocurrencies to cocoa futures. You can option it to go up or down or neither or both. You can buy an option, but you can also sell or “write” one, which can be a lot more damaging if the stock goes the wrong way. There are endless options on options: lookaheads and forced starts, vanillas and choosers, ad almost infinitum.
There are also dozens of ways to calculate an option’s shifting value, by watching its “Greeks”: its delta, the ratio of the change in price of the option to the change in price of the underlying asset; its gamma, the rate of change in an option’s delta per one-point move in the underlying asset’s price, sometimes known as its convexity; its theta, the rate of change in the value of an option over time; its vega, or the sensitivity of its price to changes in the volatility of the underlying asset. There are many others. Pause here for mental recovery.
And, of course, there are multilegged options, when you simultaneously buy and sell options with more than one share price and expiry date, which in turn yield various options strategies such as the Straddle and the Strangle and the Iron Butterfly and the Condor and the Bull Spread. If you still think options are uncomplicated, you probably passed advanced calculus. Derivatives, traders like to say, are very “mathy.”
Human beings have blithely swapped derivatives regardless, albeit in simplified form, for millennia. One of the earliest traders of options and futures was the philosopher Thales of Miletus. In 600 BC, after several terrible olive harvests, Thales studied astronomical charts and determined the next season was going to be a bumper crop. He bought a bunch of call options – paying desperate farmers a low price in the fall for next spring’s oil – and made a fortune.
Dutch traders in the 1600s speculated not just on the future value of tulip bulbs, but on an index of the frenzy for investing in tulip bulbs – an early superderivative, a bet on a bet, just as money and markets began to define the value of human endeavour for the first time. This is also when Frans Hals began to paint successive portraits of traders who age over the years, who get richer but also more haunted. They seem to be trying to figure out if their hunger for a deal was worth it.
It wasn’t until 1973, when Fischer Black, Myron Scholes (born in Timmins, Ont.) and Robert Merton figured out the math to standardize the pricing of options, that the instruments began to go ballistic. (Mr. Scholes and Mr. Merton later won the Nobel prize for their calculations; Mr. Black died before the recognition, but he lives on in the Black-Scholes model, as it’s known.)
The Chicago Board Options Exchange opened the same year, and suddenly what had been a sideshow to the equities market was transformed into a math nerd’s amusement park. Before computers took over, traders roamed the trading floor with slide rules in their back pockets. By 1984, the value of assets traded on the CBOE was second only to the New York Stock Exchange.
Professional derivatives traders quickly developed a reputation: They loved risk and volatility, the twin dervishes that scared the pants off everyone else, because that’s where the biggest potential wins were. They weren’t investors. “An investing personality is anybody who used to be in the bond market,” explains Ben Hunt, a former hedge fund manager who now writes Epsilon Theory, a research newsletter. “The bond market is enormous. And it really is based on fundamentals: Can that company pay its obligations under this bond?”
“But traders are poker players,” Mr. Hunt says. “As a poker player, you know how important the size of your stack is. You know how important it is where you are at the table, whether you have to bet first or second or third. That is the defining characteristic of a trader – and the defining characteristic of almost all the stock market today.”
These days, for reasons no one fully understands, that love of risk seems to be contagious. (“It’s called Zoom relief,” my brother Tim, a former broker, says. “You have no risk in your life, so you start trading futures.”)
In 1984, when the Toronto Stock Exchange introduced options and futures trading, 9 per cent of Canadians owned equities. Thirty-five years later, more than half invest their savings, and more and more are doing it themselves. In the first nine months of 2020, Canadian investors opened two-and-a-half times more online brokerage accounts than they did in the same period a year before.
But derivatives mania is a brand-new thing. Trading in options contracts tied to single stocks exploded by 77 per cent in the six weeks up to mid-February, compared with the first six weeks of 2020, a new record. The value was almost equal to the trading in the underlying shares themselves. That’s a big change. And it doesn’t seem to be abating.
Just this past week, a Wall Street investment firm launched the VanEck Vectors Social Sentiment Exchange Traded Fund, an indexed basket of securities that uses artificial intelligence to monitor the chatter about them on social media. The stock symbol is BUZZ.
Next month, a San Francisco startup plans to create a derivatives exchange on which investors can bet on yes-or-no questions – say, will Canadians have vaccines by September? Investors in the venture include Charles Schwab himself, billionaire private equity king Henry Kravis and Justin Mateen, a co-founder of Tinder, the dating app. The derivatives action is getting wilder and more speculative by the day.
Why this new, widespread hunger for risk? “The only thing that has changed is that derivatives are more popular now, and the investment culture has become more liberal,” says David Rothberg, a partner in Toronto’s Niagara Capital who started to trade options and futures four decades ago, after abandoning acting and betting on baseball games. “The investment culture was minuscule back then,” Mr. Rothberg remembers. It was also absurdly cautious by today’s standards: Canadian pension funds weren’t allowed to invest in equities, only bonds. That made derivatives cowboys like Mr. Rothberg even more rarified, as they speculated on gold futures (the price of gold rose to $800 from $100 an ounce between 1978 and 1980) and currency derivatives that sometimes had unheard of 70-per-cent returns on investment.
But Mr. Rothberg has also understood the relative meaning of risk – both its enormity and its irrelevance – since he was a young man, when he won a Canada Council grant to make a documentary and immediately lost it in a famous standing poker game at the Crest Grill in Toronto. He left, walked over to the El Mocambo nightclub and stared at himself in the bathroom mirror. “I thought to myself: At least you know you’ll never feel worse than this.”
Gerry Sheff, who co-founded the investment firm Gluskin Sheff + Associates (he and Ira Gluskin later left the firm), describes the domain of derivatives speculators as other-worldly. “Some of these guys would go from being worth $1-billion to $500-million in a couple of days, and still stick to their convictions. Not many people want to do that.” But to a trader, risk feels like reinvention.
If you want to see how completely derivatives trading has been transformed, and how it might become even more popular, behold Tom Sosnoff.
Mr. Sosnoff is the Chicago-based co-founder, co-chief executive and, most importantly, house philosopher at Tastytrade, an online weltanschauung devoted entirely to retail investors who want to trade options and futures, often on margin. Mr. Sosnoff is, at this very moment, preparing to bring Tastytrade to Canada.
That will present challenges. Canada has stricter rules than the U.S. around discount retail derivatives trading. It isn’t possible to trade through Robinhood, the low-cost self-directed cellphone trading app, in Canada. It is possible to trade futures and options on Toronto-based Questrade (and on margin), but there are restrictions.
Wealthsimple, on the other hand, doesn’t offer options or futures trading at all on its no-fee app. Michael Katchen, Wealthsimple’s CEO, walks a fine line between offering clients investment advice – which a discount brokerage is not allowed to do – and keeping them away from risk. “There is nothing inherently wrong with options or margin,” he says. “The problem is, they can be very risky, especially in the hands of people that don’t know what they’re doing.”
But Canada is already Tastytrade’s second biggest audience, with 10,000 daily viewers (India is No. 3). With competitors breathing down its neck, Wealthsimple has already promised a more liberal trading platform in the near future.
Mr. Sosnoff is 63. He has shoulder-length grey hair and wears a backward newsboy cap. He graduated with a BA in political science in 1979, thinking he might go into law or politics. But a nasty recession convinced him to take an internship at Drexel Burnham Lambert, where he met some traders and “got addicted to options.” He made 600 trades in his first six months.
When another firm offered Mr. Sosnoff a trading account of $50,000 if he moved to Chicago, he leapt, eventually becoming a trader on the floor of the Chicago Board Options Exchange. “I got on the floor on the first day, all the screaming and yelling, and I was around people that looked like me, that sounded like me,” he says. “I felt like I’d finally found where I was supposed to be in life.”
Like Mr. Rothberg – and Mr. Battle today – Mr. Sosnoff wasn’t afraid of chaos, even though “I had no idea what was going on. I was completely clueless. It took me months and months and months to figure out how to make a penny.” He read a book or two about options, but they had no practical application in the ferocious trading pit. Here, again, he sounds like Mr. Battle. “Trading to me wasn’t a game of analytics,” Mr. Sosnoff says, “but of mental strength.” He tried to be a grinder rather than a flashy trader. “My whole thing was to try to make $1,200 a day, or $2,500 a day, or $50,000 on a crazy day.”
By his third year, he was walking around with $10,000 in his pocket. “My father was a civil rights lawyer making $70,000 a year, fighting for his life all the time. And my third year out of college, I’m making $1-million a year with my eyes closed. I couldn’t even tell my parents what I did for a living.” Mr. Sosnoff stayed for 20 years, hauling in “I don’t know, $25-million, $30-million. Something like that.” His current net worth has been estimated at $100-million.
Of course, it wasn’t the money that attracted him. (“It’s never the money,” Mr. Rothberg observes. “It’s always the making that makes people happy.”) Mr. Sosnoff loved the mental rigour of trading derivatives. “It was also a violent, vicious game,” he says. “That’s why only about two or three or five per cent of the people survived. I lived for crazy. I wanted a maximum amount of insanity and chaos, because that’s when I made the most money.”
By the late 1990s, however, Mr. Sosnoff could see the writing on the trading pit wall. He turned to Scott Sheridan, his trading partner, and said: “We’re going to be replaced by computers. And I have an idea.”
His brainwave was to create an online trading platform for individual investors that specialized in stocks and stock options and, shortly thereafter, futures and more options. It took Mr. Sosnoff and Mr. Sheridan three years to figure out how to do it, with lots of technical help. They called it Thinkorswim, and took the company public. Five years later, in 2009, TD Ameritrade bought it for $750-million.
By then, Mr. Sosnoff was fed up with the way financial and trading news were being presented to the public, and had a new idea: “No news, no fundamental analysis, no technical analysis. Just quantitative analysis and math.” Two years later, Mr. Sosnoff and Mr. Sheridan and Thinkorswim chief financial officer Kristi Ross launched Tastytrade – the vehicle in which they now plan to bring derivatives trading to the average Joe, thereby popularizing the stuffy old world of derivatives finance.
Tastytrade is an “online financial network that provides actionable trading content to knowledgeable retail traders” – the entire universe of options and futures on a single screen, 24-7 streamable. Every weekday, the site produces eight hours of original, commercial-free live talk about options and futures trading, packaged into more than 50 shows and segments hosted by 20 online traders – ”the guys and gals of Tasty Trade,” complete with comedy and musical interludes.
It’s like watching a sexy twentysomething breakfast TV talk show, except that the hosts have higher IQs and speak the complex lingo of derivatives. They kibbitz about the weather and the news and their sweaters, and in the next breath are chatting up the intricacies of bond switcheroos. “We’ll help you navigate the markets, find actionable trade ideas and keep you chuckling all week long,” Tastytrade promises.
“Together we will focus on empowering the self-directed investor and change the way people perceive and engage with financial markets,” Mr. Sosnoff insists. (And Tastyworks, his firm’s online brokerage, will profit from their order flow.) There’s a show called Futures for Rookies and another called Options Jive. I am not kidding. The vibe is “rock on, dude”, but the research team is packed with PhDs and quants, and the chat is bewilderingly technical. Tastytrade is the revenge of the derivatives propeller-heads.
It’s only later, toward the bottom of the screen, that you see the disclaimer, “Margin increases risk, learn more,” and hear a recorded recitation from “Turbo Tracey,” a high-speed voice that races through a raft of legal disclaimers. Among them: This is not investment advice and these people are not licensed financial advisers.
In one of the most popular segments on the ever-fizzing site, Mr. Sosnoff and co-host Tony “The Bat” Battista take audience suggestions for new options trades – which Mr. Sosnoff then enacts, with real money, in real time, on the real options exchange. Watching Mr. Sosnoff enter data from his chair is weirdly compelling: The segment has the practical charm of a YouTube video that shows you how to fix a leaky faucet, except with good-looking people and the tempting possibility of making a killing thrown in.
No wonder Tastytrade has 900,000 viewers in 190 countries. And Tastyworks has so far opened more than 250,000 accounts, Mr. Sosnoff says, of which 140,000 actively trade options. That’s a fraction of the 30 million online accounts at Charles Schwab and Fidelity, the two largest U.S. retail brokerages, but Tasty’s racy platform makes Schwab and Fidelity look like maiden aunts. This is true even though Tasty’s trading clients have an average age of 50. Mr. Sosnoff claims that, in the past year, a third of the operation’s new accounts have been opened by people under the age of 33. He must be onto something: Last month, Tastytrade and Tastyworks were acquired by IG Capital for a frisky $1-billion.
As the GameStop frenzy wanes and waxes (it did both this week, closing at $137.74 on Friday), I call Mr. Hedge. He’s just 43, but he’s old school, and believes that making money is incompatible with having his name in the newspaper, hence the alias. Mr. Hedge runs a neatly profitable hedge fund with assets slightly shy of $3-billion, parts of which he invests for well-known pension plans. We all need Mr. Hedge to make money.
Mr. Hedge is a big fan of using derivatives to protect (or hedge) his investments from downward dips in the market, one of their traditional functions. If he buys a put option, rather than a call, on the S&P 500 index, it gives him the right (but not the obligation) to sell if the index reaches a specified level. The index has traded near 3,800 lately, and if Mr. Hedge wants some insurance against a stock market crash, he can buy a put at, say, 3,300. That way, he can lay off some of the decline in his stock portfolio for a relatively small amount of money.
“I manage nearly $3-billion,” he points out. “I own Microsoft, I own Procter & Gamble, a lot of stocks. And my worst nightmare is we get a big crash like what happened last March. But I can take a very, very small part of my portfolio – like not even a per cent – to buy put options that pay off if the market goes down. When the market’s going up 1 per cent every week, who cares? And if we ever get a big crash, I’m good.”
What Mr. Hedge is not keen on is the soaring number of speculative options trades made by a growing army of individual retail investors over the past year, most famously in GameStop, a company with poor prospects.
Instead of buying the company’s stock, the gamers bought vastly cheaper call options, and then touted GameStop on the internet. Every time the stock price rose, brokers had to buy shares to hedge the options they had sold to the gamers and others, which drove the price even higher until the pyramid collapsed.
“So you get this impact,” Mr. Hedge says, and he has a slightly resigned sound in his voice, “where a $15,000 retail trade on way-out-of-the-money call options can end up with a broker having to go buy $1-million worth of stock. Meanwhile, the retail investors are co-ordinating and communicating with each other on social media, to drive the stock up. There are rules for people in my business about stock manipulation. But there are no rules for millions of users on Reddit.”
And Mr. Hedge thinks the after effects of the GameStop fracas have only just begun. Retail derivatives speculation, judging from call option activity in the market, is at an almost unprecedented high. Meanwhile, companies with weak balance sheets whose share prices used to be knocked down by short-sellers (the way Bre-X was, the way Enron was) are soaring.
No one knows yet if those trends are related, but they make Mr. Hedge nervous: Weak companies are propped up, and a fledgling retail market is exposed to a possible market collapse that could take everyone with it.
All of which gives a sturdy investor like Mr. Hedge some pause. Not that anyone’s holding a bake sale for his kind. By now, it’s well known that hedge funds and institutional investors also piled into the GameStop melee, driving the stock higher and profiting handsomely while many retail investors bought late and lost money.
But sheer speculation has never been Mr. Hedge’s main game; he prefers growing the economy. “All of a sudden, we’ve been dwarfed by this huge group of active investors who care nothing about valuation or fundamentals. It’s all story and pump. And so the markets have become – well, a casino is an understatement.”
“So, what you’re saying,” I ask, “is that all these new retail investors might be better off in the long run by investing in value, rather than in options?”
Mr. Hedge’s sigh sounds like it is being released from deep within the Earth. “Yes,” he says. “Go read Warren Buffett’s annual reports, listen to his past annual meetings, go buy great companies like Costco or CN Rail. And don’t be a gambler, be an investor. But that is so not cool right now. Nobody’s doing that.”
Predictably, Mr. Sosnoff has no time for such traditionalist caution. However shallow and cheesy the GameStop blowout was, to him the small-trader explosion is “a transformational, defining moment in the history of finance. Because this was the coming-out party for individual investors transitioning from passive to active. And for an entire generation to engage in finance.”
“The old-school traditional hedge fund managers are conflicted,” he continues. “Because that entire industry makes its living – a great living – from telling people that they’re not capable of doing it on their own. I’ve been doing this for 40 years. And I have no idea what might happen in the market this afternoon, tomorrow or next week. And I don’t care if somebody else has been looking at the market for only an hour. We have the same exact opportunity to make or lose money. So what is the difference between us? It’s just a little bit of know-how with respect to product and strategy.”
The legacy world is dying. Tastytrade, on the other hand, is making sophisticated derivatives trading more accessible. “This is going to be a world where everybody pumps their own gas in the next couple of years,” Mr. Sosnoff says. He even ventures that the mental grip and discipline an average small investor needs to trade derivatives will help create smarter, more discerning citizens – ones less susceptible to, say, QAnon conspiracy theories.
“My kids are trading away right now, and all their friends are too,” he says. “I think it’s the greatest thing in the world. They’re so much smarter about finance at 25 and 30 than my friends in their 40s and 50s and 60s and 70s that still have their money managed. That traditionalist, legacy, purist argument is garbage to me. The new world is taking over, right now. Everybody’s going to be capable of understanding all these different products and this technology, saving a boatload of money, by doing it themselves. By being fully engaged.”
Which reminds me of 34-year-old Mr. Battle, the rookie options trader, all over again. He lives in a country where, according to a recent Rand Corporation report, the top 1 per cent of income earners have sifted $50-trillion out of the incomes of the bottom 90 per cent (including the Black community) since 1974 – back when derivatives were launching their long liftoff. Mr. Battle seems to have a knack for handling risk and trading options. Is he planning to go back to school to become a broker?
“No, no, no, no, no, no,” he says. “College is a scam. I’m not paying anybody to learn how to make money when I’m already making money. You can teach yourself. You know, you go on YouTube, you learn how to fix your car, field strip a weapon. There’s nothing you can’t teach yourself in this day and age.” Let’s hope he’s right.
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