A recurring story concerning the recent tech sell-off is that option trading is the culprit. Retail and other investors excessively traded options to gain highly levered positions in a selected number of stocks that have shown strong momentum. The option call buying provided a positive feedback loop which further increased prices. With a small price reset and slight change in expectations, price started a sharp decline as option positions were exited. The technical reasons for this option effect include short-dated call expiration, gamma trading, and leverage loses. All are valid, yet the prior strong option buying activity was not predictive of a future sell-off.
Still, it is a good time to review the two major types of risk faced by investors, exogenous and endogenous. Exogenous risks are outside shocks to the market such as new macro information or company news. These exogenous risks change valuation and expectations. They also make sense to investors. Endogenous risks are price variability associated with the internal dynamics of markets. These are often temporary and are associated with the dynamics or imbalance of market participants. For example, excessive option trading creating feedback effects is an endogenous risk.
Most investors focus on the exogenous risks. What will happen with earnings? How do I prepare for the unemployment number or the Fed meeting? Less time is focused on the changing dynamics associated with the behavior of economic players in the market, yet these can cause significant short-term distortions in price which trigger portfolio adjustments based on changing volatility.
Fundamentals or exogenous risks will drive prices to new valuations or equilibrium levels while endogenous risk or shocks will cause distortions from valuation which create a gap between value and price. The option activity is an endogenous risk that must be accounted for, but it is not the same as a fundamental change in valuation. The endogenous risk can cause feedback loop problems that trigger risk stops, but not valuations.
The tech sell-off is real and unrelated to fundamentals; however, some of the tech excess returns were also unrelated to fundamentals. Investing and trading requires assess of both exogenous and endogenous risks.
The tech sell-off is real and unrelated to fundamentals; however, some of the tech excess returns were also unrelated to fundamentals. Investing and trading requires assess of both exogenous and endogenous risks.
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