The Financial Times has identified technology-focused venture capital fund SoftBank as the “whale” which took outsized derivative bets on frontline tech stocks listed on the Nasdaq. The report went on to say that these bets may have been largely responsible for the roaring rally in tech stocks over the past many weeks.

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For starters, who and what is a whale in financial markets?

In market parlance, whales are large investors with the money power that allows them to single-handedly move the price of a security for a brief period. Usually, financial market whales are associated with derivative bets, particularly in options. The term ‘whale’ is more commonly used in the casino industry to describe gamblers who bet in the millions over a single weekend.

What did the Softbank do to earn the sobriquet of the Nasdaq Whale?

According to the FT report, SoftBank bought billions of dollars’ worth of call options on frontline tech stocks listed on the Nasdaq.

Wait, what is a call option?

It is a derivative contract that gives the buyer the option to purchase an asset—it could be a security, commodity, or currency--at a pre-decided price on or before a particular date. It is not mandatory for the option buyer to purchase the asset; he can walk away from the trade if the price is unfavourable to him.

Give me an example

HDFC Bank shares are trading at Rs 1000. I think it could rise over Rs 1100 in a month’s time. I want to buy 1000 shares, but I don’t have that much cash. There is an option writer who will sell me Rs 1100 call options at a premium of Rs 10 per share. This means I have the option to buy 1000 HDFC Bank shares at Rs 1100, by paying a premium of Rs 10,000 (1000 X Rs 10). It will be worthwhile for me to exercise the option only if the HDFC Bank stock price crosses Rs 1100. If it doesn't, I lose the money I paid as premium. So my losses will be limited to Rs 10,000 at any point, but the gains could be unlimited.

How would SoftBank’s derivative bets have caused tech stocks in US to rally?

When there is a huge demand for a particular call option, the market takes the frenzied buying as a signal that the price of that asset is likely to go up and that some smart investors could be behind the bets. So the price of the underlying—in this case, US tech stocks—would also start rising.

Any other factor that could have driven the stock prices higher?

The players who write, or sell, the call option contracts also need to hedge their trade. For instance, the writer of the HDFC Bank 1100 call option is betting that the price of HDFC Bank is unlikely to cross Rs 1100, and so he will get to pocket the premium. But the call writer will also need to take precautions, just in case the HDFC Bank stock price rises. There are many ways in which he can do that. One of the ways is to buy a certain quantity of HDFC Bank shares. So if the HDFC Bank stock price rises, he will lose money on the call option he wrote. But those losses will be partly offset by the profit on the HDFC Bank shares with him.

On Nasdaq, many of the call option writers would have bought shares of the stocks on which they had written the options. When too many option writers buy shares to hedge their trades, the prices of those shares could flare up.

How would SoftBank benefit by buying call options in such large numbers?

If the price of the underlying shares rises, so does the value of the call options. There is money to be made straightaway by exercising the options. That is one benefit. Also, SoftBank is a technology-focused venture capital fund. So when technology shares rally, the sentiment for the sector as a whole improves. This is likely to give a boost to the valuation of unlisted technology companies as well.

Do whales win?

It will depend on a lot of factors. But if the identity of the whale is known, chances are that many opportunistic players—particularly hedge funds--will try and gang up against it. That would make it difficult for any whale to get the best prices.

In 2012, a trader at JP Morgan Chase earned the nickname of the London Whale by amassing outsized positions in credit default swaps. Eventually, JP Morgan Chase lost $6.2 billion on those bets.

First Published:Sept 5, 2020 3:30 PM IST