Market Sentiment Driven by Risk-On Behavior Ahead of Earnings Season

Traders are aggressively buying call options, a clear signal that they expect stock-market darlings to surpass the S&P 500 Index’s ascent. The signals from derivatives trading are evident as investors last week bought call options with impunity, wagering on further gains in stocks like Nvidia Corp., Uber Technologies Inc., and Tesla Inc.

The rush into call options is driven by a growing fear of missing out on the rally that seems impervious to strife in the Middle East and concern about slowing US economy and corporate earnings growth. According to Chris Murphy, co-head of derivatives strategy at Susquehanna International Group, investors are seeking protection for potential declines but their demand to hedge against losses has decreased rapidly in the past week.

Nvidia and Momentum Names See Strong Call Buying Pressure

NVIDIA (NVDA) saw a significant surge in call contracts on Wednesday, pushing volumes to almost triple those of bearish puts, its biggest gap since January. This was not isolated as there was also strong call buying in momentum names like Uber Technologies Inc., Tesla Inc., and Robinhood Markets Inc. "The week’s options flow reflects clear signs of FOMO-driven re-risking," Murphy said. "The trend is clear, with almost exclusively bullish flow, momentum call buying, as well as buy-the-dip put selling."

Murphy points out that investors are willing to take on risk by using call options because it allows them to limit the size of potential losses while still benefitting from any gains. Call options give traders the right to buy a stock at a future higher price but do not oblige them to do so, making it an attractive choice for speculators.

Mixed Signals: Tariffs and Speculative Bubbles

However, not all news is rosy as US stocks nosedived in afternoon trading on Friday after President Trump threatened to impose fresh tariffs. The losses were quickly recouped, but the uncertainty has traders confronting mixed signals. On one hand, optimism about a potential deal with major trading partners drove stocks towards record highs. On the other, the warning by Bank of America Corp.’s strategists regarding an increasing risk of speculative bubbles should be heeded.

Unprecedented Bubble Risk?

Bank of America Corp.’s strategists pointed out that traders are driving massive flows into equities with expectations of US interest-rate cuts, potentially leading to a speculative bubble. The upcoming earnings season could also test the foundations of the recent rally as forecasts continue to pour in with less-than-rosy projections.

In a macro environment as uncertain as the current one, setbacks like souring negotiations with Canada or an unexpected reversal of fortunes are also more likely than ever. Susquehanna’s Murphy notes that "using call options is still a preferred way for investors to take part in speculative rallies because it allows them to cap their losses and position themselves for gains."

Evidence of FOMO-Rush and Bubbles

Further evidence points towards an increasing willingness among traders to bet on the highest-upside stocks despite the rising risk of setbacks. Data from JPMorgan shows that retail investors are flocking to equities, often a sign of heightened risk-taking.

Moreover, a Goldman basket of most-shorted stocks is poised for its best monthly gain since February 2024 and the Invesco S&P High Beta ETF, which tracks highly volatile assets, is tracking its best quarter since March. A shift into the riskiest stocks as a way to avoid missing out on further gains underscores the prevailing appetite among traders.

Implied Volatility: Higher Upside or Speculative Bubble?

The call skew – a measure of how much traders are willing to pay for bullish exposure – has been climbing across several high-risk assets like Tesla, Coinbase Global Inc., and the ARK Innovation ETF. Options trader Tom Keen suggests this indicates "a FOMO-rush." With macro risks moving lower, traders seem convinced that prices will continue rising.

Conclusion

While optimism runs high, investors should remain cautious given ongoing tensions between the US and major trading partners as well as looming tariff deadlines. Moreover, warning signs of a speculative bubble have been sounded by analysts while forecasts for disappointing earnings await confirmation. Investors choosing to invest in these stocks must carefully consider both the risk-reward balance and their comfort level with potential downside consequences.