2.1 The Tail Wags the Dog

The Chicago Board Options exchange (CBOE) is one of the largest U.S. equities market operators on any given day. Since its start in 1973, the options market has grown from less than 1000 daily contracts to averaging over 10 million daily contracts traded. Today the total aggregate value of options contracts is roughly $400 billion. Which is insignificant compared to the U.S. stock market’s $45.5 trillion valuation. So small, in fact, that the total worth of the U.S. options is less than 1% of the total worth of the U.S. stock market. This may seem rather insignificant, but the impact and significance of options goes beyond the surface of monetary value. How large is the options market, actually? And how important is it?

An option is a financial instrument that gives someone the right, but not the obligation, to buy or sell an underlying security, index, or ETF, at an agreed upon price, and date. Usually, an options contract represents 100 shares of the underlying. This leverage allows an options buyer to pay a relatively small premium for more market exposure than they would get just buying shares with the same amount of capital. Leverage is more than using less capital to gain more potential profits, it quite literally, moves markets. When someone buys an options contract, a market maker must hedge all the delta on that contract. For one contract that may not be that much delta; For ALL the contracts, gross market delta is $3 trillion, or 6.5% of the stock market’s value. That’s right, the $400 billion in total options contract value is worth over $3 Trillion in just delta hedging. Clearly there’s some importance to the options market.

The volume of which options contracts are traded is quite large, over 10 million every day. This especially holds true for the $SPX (S & P 500 indices) contracts. Comparing one day’s volume for every stock listed in the S&P 500 to the total delta traded on those stocks, gives ~80%. Which means that 80% of all volume on a stock is attributed to delta hedging. If the volume on index options like $SPX is about 80% of the dollars traded on the underlying, and index futures volume traded accounts for 400% of the underlying volume, one thing is clear:

The stock market is now primarily driven by derivatives trading