Monday, January 21, 2013

Options and stock price action

Last week's post, the first, was quite general with a few topics touched upon. Today, I would like to be more specific and try to be original while talking about Apple. A daunting task.

From the gossip to our topic

There is currently much gossip around the iPhone producer and the articles, blogs, research papers, TV shows, etc. that focus on it are simply incalculable. The noise was brought to a particularly high level this past week because of an article in Monday's Wall Street Journal that caught the attention of many. The paper reported (here) that the tech giant could have been cutting its orders to suppliers, which could indicate lower demand for its end product. Be it the cause or not, the stock was hammered in the pre-opening Monday, causing it to start the week around 502, a stark difference to the previous Friday's close at 520. This -3.46% move was especially remarkable in an otherwise flattish market opening. 

I had read lately about the fact that Friday the 18th of January was an important milestone for Apple's share ahead of the quarterly results on the 23rd. Some bulls and pundits on the stock were pointing at option traders when looking for what could be preventing price action on the upside: "everything would be cleared on the 18th", "go long at the end of the trading day on Friday" were among the things one could read. It then  appeared to me that options could have a bigger influence on stock prices that I thought, and this is what I wanted to investigate with today’s topic.

Apple’s price action this week

After the sharp down move on Monday morning, the stock neither continued its slide, nor embarked in the positive territory as did the broader market (S&P 500 at +0.7% for the week). It rather hovered around the USD 500 mark.The price did make a move on the downside to USD 483 on Tuesday and a swing north around the USD 510 on Thursday, but it finished the week at precisely 500. This level acted as magnet to the stock and this is where options could be blamed.


Options: backstage

Let us first take some time to quickly review some selected concepts on options:
  • The January option expiry is the busyiest of the year. Contracts for options that come due in the first calendar month are listed two year in advance, unlike other month’s contracts that are available around 9 months beforehand. This means that positions for January have a long time to build up and that makes it a crowded place.
  • As we are nearing their expiration dates, and if we are moving close to their trigger price, options on a specific strike become very sensitive to movements in the underlying.
  • When you enter an order to buy or sell an option, it is probable that a market maker is on the other end of the trade doing the opposite. He is not trying to bet against you, he is just acting as, well, a market maker.
  • The market maker is interested in the margins he gets from trading options; he sells at dearer prices than the ones at which he buys, like any sensible merchant. As he does not want to take a market risk with the positions that result from his business, he will make sure that his option book is properly hedged. One way of doing this is achieved by buying and selling stocks. 

What about Apple?

Let’s look at Apple’s January options Open Interest for Friday; this number gives us the amount of contracts that were traded at different strike levels. That is what Schaeffer's Investment Research did in an article (here): their chart below clearly indicates where people were holding calls and puts contracts for Jan 18th. Specific strikes clearly stand out, like the USD 500 with a total of more than 100k contracts outstanding (calls and puts combined). Let’s think about it: if Apple closes above USD 500, and rounding the calls to 50k, this would mean that 5m shares,or USD 2.5bn worth of Apple, would change hands on this day just with these options. This is just under 1/4 of the 21m shares average daily volume over the past month. Huge.


Do option traders manipulate the prices?

If the closing price is precisely USD 500, options traders that sold options at that strike are at peace. This portion of their book, probably an important one as the chart above indicates, is perfectly safe, as corresponding calls and puts will expire worthless. If it was not the case however, they would need to buy or sell underlying Apple share in order to hedge themselves (this is called delta hedging). The trading activity resulting from the hedging process causes the underlying stock price to be anchored or “pinned” to the busy strike (more detailed info about these dynamics here and here).  Trading on an underlying position that makes up 1/4 of the daily volume can very well influence the market and push you to a specific level, especially if it is not too distant from the current price. This is maybe what we witnessed on Friday. It seems that options traders do not manipulate the market, they rather pollute it and can make it stall somehow.


Option expiries and open interest seem to be important topics, I found plenty of research and trading strategies built around them by preparing this post. Even if I believe that companies’ earnings and other more fundamental aspects have a bigger impact on price in the long term, options markets can be interesting to analyze for shorter term investment time frames. I find it interesting to see that the 580, 550 and 500 levels were all kind of “magnetic” since the beginning of November 2012.They all appear to be busy strikes on the Open Interest chart.

That will be it for today. I hope to come back soon with another post.

I am a financial adviser working for a private bank in Belgium. This is my personal weblog. The opinions expressed here represent my own and not those of my employer. 

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