Japanese conglomerate Softbank Group Corp. (SFTBY) is notoriously remembered for its disastrous $18.5 billion investment into shared workspace startup WeWork.
But it’s now in the headlines for a rumored $4 billion options trade that made the firm billions in profits…
Even as it caused the tech pullback we’ve seen over the last few days.
At least, that’s the Big Media version of events.
The real story is less pretty.
But it does show how you can book a nice profit, too.
Softbank Doubled Down on Big Tech
Before the WeWork debacle, Softbank had a reputation as a successful early-stage investor in startups, including Slack Technologies Inc. (WORK), Doordash, and Uber Technologies Inc. (UBER).
And at the height of the WeWork mania last year, WeWork looked like another notch on Softbank’s belt. After all, Softbank valued the startup at a whopping $47 billion, which would have netted the conglomerate huge profits.
But then WeWork filed for an IPO and potential investors got a closer look at the startup’s books. And that was the beginning of a huge financial disaster.
The end result was that Softbank had to buy WeWork’s CEO and founder out, significantly cut down operations, and cancel the IPO.
In May of this year, Softbank quietly admitted that WeWork was worth at most $2.9 billion. That’s a $15.6 billion loss on its investment. Assuming the $2.9 billion valuation is any good…
So maybe it should not have come as a surprise that Softbank’s investment approach changed this year.
On August 10, it was revealed that a new Softbank investment arm was going to invest more than $10 billion into public stocks, focusing on the largest, most hyped-up names in tech. In fact, the investments read like a who’s-who of this summer’s tech rally:
- Alphabet Inc. (GOOG)
- Amazon.com Inc. (AMZN)
- NVIDIA Corp. (NVDA)
- Adobe Inc. (ADBE)
- Tesla Inc. (TSLA)
- Netflix Inc. (NFLX)
- Microsoft Corp. (MSFT)
- Zoom Video Communications Inc. (ZM)
- Square Inc. (SQ)
- PayPal Holdings Inc. (PYPL)
- Shopify Inc. (SHOP)
- Spotify Technology SA (SPOT)
- Etsy Inc. (ETSY)
To make things even stranger for a company that used to invest in companies before they went public, many of these investments were done through a subsidiary so that Softbank wouldn’t show up as a shareholder.
As you’ve probably guessed, that’s highly unusual.
And now we know why. According to the Financial Times and the Wall Street Journal, Softbank decided to juice these tech investments by spending an estimated $4 billion on buying calls on these same stocks.
As you probably know, a call is an option that gives the owner the right to buy the underlying stock at a set price at a set time. Call options allow you to control an expensive asset (the stock) for a set period of time at a fraction of the cost of buying the asset outright.
Simply put, buying calls is a bet that the underlying stock will go up in price.
There’s nothing wrong with buying calls, of course. It’s a key component of many traders’ portfolios.
But buying $4 billion worth of calls on a few specific stocks, all in a manner of weeks is a different matter entirely.
That’s no longer a bet that those stocks will go up.
It can actually force those stocks to go up…
Softbank’s $4 Billion Set the Market Trend
For every call that Softbank bought, someone else must have sold or “written” a call. And just like buying a call is a bet that the underlying stock will go up, selling that call is a bet that the same stock will go down.
After all, Softbank gains the right to buy the stock at the set price from the call seller. The seller has nothing to say about it, it’s all up to Softbank.
That’s a risky position to be in. If you sell a call option on Tesla, for example, thinking Tesla shares will go down and you’re wrong, you could be in a lot of trouble. You may end up having to buy Tesla shares at market price and sell them to Softbank for way less.
You’d be forced to trade at a loss.
What call sellers can do to offset the risk is sell the call and buy the underlying shares at the same time. That way, if they were wrong, they already have the shares in hand and don’t have to buy them at higher prices.
Usually, that’s fine.
But when Softbank poured $4 billion into buying calls on just a few tech stocks, things quickly went haywire. With that much new demand for calls, the price of calls went way up.
Money makers and hedge funds were eager to sell record amounts of calls at these higher prices.
And they really were record amounts. According to Goldman Sachs Group Inc. (GS), July was the first month ever in which the average daily value of options being traded was higher than that for stocks:
A huge amount of this new option volume was in options with short expiration dates:
Short-dated options like that force the call sellers to hedge quickly, meaning they have to buy the underlying stock immediately.
You may already have guessed what happened. With $4 billion of call options being bought, money makers and hedge funds started buying tech stocks as fast as possible, to hedge their risk.
According to Big Media, this frantic buying pushed the stocks up so high that Softbank’s call options paid off. That gave them even more ammunition to buy more call options, forcing the call sellers to buy even more stock to hedge, giving Softbank even more profit, and the cycle continued.
In short, the story is that Softbank made its tech investments pay off by pumping the market with $4 billion of call options.
The second part of Big Media’s story, unsaid but implied, is supposed to be that now that Softbank’s play has been revealed and they’ve cashed out, the tech rally is over and another crash is coming.
But the truth is, Softbank didn’t create the fastest stock rally in history all on their own with just $4 billion.
They couldn’t have…
Robinhood Traders Provided Plenty of Backup
Take a look at this chart from Goldman Sachs again:
It shows that for the first time ever, more single stock options were traded than stocks. It can be hard to tell from the highly condensed charts, but this phenomenon started in July, when single stock option volume hit 114% of stock volume.
July, of course, is about a month before Softbank revealed its new strategy.
Now, we don’t know exactly when that strategy went into effect, but chances are that billions of dollars in completely new spending would not have started in earnest without market players finding out.
As Goldman pointed out earlier this year, individual investors have for the first time ever charged into the options market in the spring. According to Goldman, when it comes to stocks, “2.3% of all volume is made up of trades for $2,000 or less.”
When it comes to options, “13% of all trades are for 1 contract.” Only individual investors would bother buying single options contracts, or trade $2,000 at a time.
In other words, it was the influx of individual investors into the market that pushed up options activity, as these charts from Goldman show:
Free and easy-to-use apps like Robinhood helped by making options accessible. Perhaps with shutdowns and sports being cancelled, there just wasn’t much to do but play around on the stock market.
Whatever the reason, this “Robinhood” effect primed the market for Softbank’s later strategy.
In fact, as early as mid-May, options markets were in a very strange place. Major institutions mostly use options to hedge investment in the underlying stocks.
They buy shares in companies, and then buy put options to protect themselves from those shares sinking. A put option is like a call option, but it makes money when the underlying stock goes down.
Because of this, there are usually more put options traded than call options. The ratio between the two is called the put-call ratio or skew. In this chart, a reading above 1 means there are more puts being traded, which is usually the case, while a reading below 1 means calls are in the majority:
As you can see, since mid-May, the options market has almost constantly been skewed heavily toward calls. That is highly unusual.
But given the large number of new individual investors using options to bet on the tech rally, as Goldman’s charts show, it makes sense. All this option activity also helped spur the rally on, feeding it.
Then when Softbank joined in with its $4 billion, you can see the put-call ratio staying down for longer.
In short, Softbank may have profited from this summer’s options party, but individual investors probably started it on their own.
But despite what Big Media would have you believe, this party is long from over.
My Favorite Stock for a Continued Tech Rally
Take a look at the put-call ratio chart again:
On the right, you’ll see that for a brief point in early September, more puts were traded than calls. But after that, the ratio went back down below 1.
In other words, but for that short blip, calls are still in the majority.
If Big Media is right and the tech rally was single-handedly created by Softbank’s $4 billion call option spree, then this chart shows that Softbank still hasn’t cashed out. They’re still in the game, still buying calls.
As you saw above, it’s more likely that Softbank just jumped on the bandwagon that individual Robinhood traders had already started. In this more likely scenario, most investors – and probably Softbank too – are still buying calls, doubling down on the tech rally.
Either way, as long as these record amounts of money is flowing into calls, the tech rally should keep on going.
And that means the hot tech stocks that have been driving this rally are still buys on any dip.
And this current dip has me loving Microsoft (MSFT). They continue to grow their Azure cloud business faster than their main competitor over at Amazon Web Services. And with their gaming services already growing at a 65% annual pace, and the rollout of the new Xbox Series X platform scheduled for November, the growth of the MSFT gaming franchise will get a big shot in the arm. And this pullback to a key support level gives us a great entry price:
I love picking up extra shares or call options in the $205 – $210 strike price for a run up into the November Elections that coincide with the big Xbox Series S launch.
Great trading, stay safe out there, and God bless you,