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Perpetual Money Machine

Posted on September 15, 2020

“This is extraordinarily risky speculation.” – Benn Eifert

2020-09-15_Scrabble_Tiles.jpgWouldn’t it be nice if we could design a machine that, once up and running, required less energy to operate than it was able to produce? If possible, such a machine could supply all the energy needs of the entire world for a fraction of the current cost (or at least until the machine broke). This concept is known as perpetual motion and dates at least back to the Middle Ages of human history. In fact even Leonardo da Vinci sketched a handful of designs for machines that could make “free energy.” Unfortunately, as science progressed and hypotheses such as the First Law of Thermodynamics  (energy can neither be created nor destroyed) were proven to be true, mankind came to the realization that perpetual motion is impossible. Today, the same hubris that mankind showed for hundreds of years in chasing after a perpetual motion machine is being manifest in the stock market through a relatively new strategy we will call the perpetual money machine.

It wasn’t too long ago that trading costs in the stock market were not insignificant. Thirty years ago, if someone wanted to purchase a stock, bond or mutual fund, they had to call up a broker and pay what would now be considered an exorbitant commission to execute the transaction. Today, that business model is dead as the internet has democratized the financial system and almost completely eliminated transaction costs (don’t worry…the big banks have still figured out a way of how to make money off of your account, but that is a topic for another day). On the surface, reducing transaction cost is a great thing as it allows investors to keep more of their hard earned money, but the unintended consequence of doing so is that it has increased the level of speculation and trading frequency by the average investor in the market. In addition, we now have aps on our phones that have “gamified” investing (if you can even call it that) in the stock market which is just adding more fuel to the speculation fire.

So with that backdrop, let me try to explain how this dynamic has given rise to a perpetual money machine by walking through a hypothetical example. As a warning, this is a bit complicated so please bear with me (or eject entirely…it won’t hurt my feelings). Okay, here we go.

Let’s assume that Investor A really likes Stock Z and wants to bet on it going up in price over the next couple days/weeks. Rather than simply buying the shares outright, the easiest way for them to make a leveraged bet on the stock is actually to buy a call option. A call option is a contract that gives Investor A the right, but not the obligation, to buy Stock Z at a given “strike price.” When buying a call option the hope is that the price of the stock rises to or above the strike price of the option; the higher above the strike price, the more money Investor A makes. If the call option expires before the share price rises above the option’s strike price, Investor A loses whatever money they spent purchasing the call option.

Let’s assume that Stock Z trades for $100/share and a short-term call option costs $5/share. If Investor A wanted to buy 1,000 shares of Stock Z outright, they would need $100,000 (1,000 shares * $100). Alternatively they could buy call options on those same 1,000 shares for only $5,000. In other words, they have put up 1/20th of the amount of money to gain exposure to the same number of shares as someone who purchases the stock outright. In doing so, if the stock rises significantly above the call option’s strike price Investor A stands to make a tremendous return on their $5,000 investment. Conversely, if the stock falls or remains flat they could easily lose their entire $5,000 investment.

The next layer is to understand the other side of the transaction. In order for Investor A to purchase 1,000 option contracts someone has to be willing to sell an equivalent amount. This typically takes the form of a market maker or dealer, which is a large institutional trader who makes money by selling securities to one investor for slightly more than what they purchased them for from another investor (known as “the spread”). Obviously, the timing of those two transactions (the sale and the purchase) don’t always happen simultaneously so the market maker is exposed to potential price movements between the purchase and sale transactions. In order to mitigate this risk, dealers end up constantly hedging the securities on their books.

So back to our original example…Investor A has purchased 1,000 call option contracts from a market maker who is now short the same number of call options. Being short a call option reverses the economics of the bet so that the dealer stands to lose money if the stock goes up, but will keep the proceeds from Investor A’s purchase if the stock stays flat or goes down. In order to hedge the risk of the stock going up they go into the market and purchase shares of the stock outright. The number of shares they purchase depends on the “delta” of the call option in question. Delta is a measure of how much an option price changes relative to its underlying stock. In our example let’s say the call options have a delta of 0.5 which means that for every $1 move in the stock, the option in question is expected to move $0.50. So in order to hedge the initial transaction, the dealer must go into the market and purchase 500 shares of Stock Z. To recap, we have an initial $5,000 investment from Investor A into 1,000 call option contracts which then triggers a $50,000 purchase of Stock Z by the market maker who sold Investor A the options.

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Now let’s say on day 2, Stock Z goes up 5% to $105/share. Theoretically, the call option should be up $2.50 to $7.50/contract because it has a delta of 0.5, but delta is not static. In general, the delta of a call option will increase as the stock price increases over short periods of time. The how and why of this dynamic is beyond the scope of this post, but the term for the rate of change in an option’s delta is known as gamma. The higher the gamma, the harder it is for a dealer to hedge because they are constantly having to adjust their positions in order to remain “delta hedged.” In our example, due to the quick uptick in the price of Stock Z, let’s assume the call option delta moves up from 0.5 to 0.6. In order to fully hedge the 1,000 short calls with a 0.6 delta, the market maker needs to be long 600 shares of Stock Z. Since they are already long 500 shares from the original transaction, they simply go into the market and purchase 100 more shares (100 shares * $105/share = $10,500) to bring their share count up to 600 total. Again recapping, we now have a $5,000 initial outlay into 1,000 call option contracts which has triggered $60,500 worth of stock purchases by the market maker as a hedge.

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On day 3, stock Z jumps up another $5 to $110. Again the option delta moves up due to the upward move in the stock over a short period of time and the market marker is forced to purchase more shares of Stock Z in order to hedge. If the delta goes up to 0.7, the dealer now needs 700 shares to hedge the 1,000 short call positions so they purchase another 100 shares for $11,000. Again recapping, Investor A has spent a total of $5,000 on call options which in turn has produced $71,500 worth of stock purchases by market makers looking to hedge their position.

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The conclusion from this rather long example is that a small outlay by a speculative market participant into call option contracts can in turn produce a much larger purchase of the underlying stock. Purchasing activity puts upward pressure on the stock price which further exacerbates the upward momentum in the price and is exactly what the option speculator is wanting to achieve…hence the perpetual money machine.

In isolation a couple thousand dollars of call option purchases triggering tens of thousands of dollars of purchases in the underlying stock won’t materially impact the stock price, but when a heard of Investor A’s are all doing the same thing at the same time (ex. purchasing the same stock ticker pulled out of a bag of scrabble tiles) through their gamified phone app, the impact can be significant. At present, small option traders are making these types of bullish call option bets at 5x their normal average volume (compared to no change in their bearish put option activity) with the vast majority of the activity being concentrated in very short-term (less than a month) options on mega-cap tech stocks.

No one knows how or when the perpetual money machine cycle will end (there are some interesting theories that we won’t go into for the sake of time), but unless one believes that trees truly do grow to the sky, then it is safe to say that eventually the music will stop and the losses with be stratospheric for those that continue to press their bets. As volatility maven Benn Eifert, who was one of my sources in understanding this phenomenon, stated in the opening quote, this type of speculation is extraordinarily risky. In the meantime, market participants should expect higher levels of volatility (both up and down) during this time of elevated economic uncertainty and speculation.


elliott_headshot_bw.jpgAuthor Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.


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