The Battle: Rally Mode vs. Options Expiration

December 7, 2012 (11:30 am)

Options Expiration

One important aspect of short-term investing that we haven’t discussed is the concept of options expiration. This concept most significantly affects Apple, since more options on Apple shares are traded than any other security. Here is the general concept. If you buy a call option on a stock, you are buying the right to purchase that stock at a predetermined strike price by a predetermined date. The option buyer pays a premium to the seller for that right. It’s also crucial to keep in mind that the vast majority of options are sold by large institutions that are looking to collect this premium. It is those sellers that dictate Apple’s direction and close it where they have to pay out the least amount.

So why does this matter? It comes into play because these traders have an incentive for these options to expire worthless (i.e. the share price is below the predetermined strike price by the expiration date of the option). If the option expires worthless, they keep the premium and don’t have to give up their shares. It’s a win-win for the institutions. By way of example, let’s say you bought an Apple January $600 option for $5.00.  This gives you the right to purchase shares of Apple at $600 by the January expiration date, no matter where the shares are trading when you decide to exercise the options. You paid a $5.00 premium for the ability to do this.  Therefore, if the shares are above $600 at expiration, you break even on your investment (the strike price plus the premium). Anything above that is a profit.

Now let’s say that the shares close at $590. You wouldn’t exercise the option, because you’d be able to buy the shares cheaper in the open market ($590) than you would by exercising the option ($600). You also lose the premium that you paid for the option.  On the other side of this trade is a large institution. If the shares close below the strike price, they benefit in two ways:

  1. They keep their shares, since you won’t exercise your option to call their shares away.
  2. They keep the premium that you paid them.

Since shares of Apple are very expensive, a large number of retail (small and typically unsophisticated) investors have resorted to purchasing call options instead of the underlying shares. Since taking in the premium is so profitable, institutions are more than happy to sell options to retail investors. They then systematically force the shares down at options expiration so they don’t have to pay out the buyers and instead allow the options to expire worthless. The higher the prices go, the more they’d have to pay out to those option buyers. Therefore, they want the shares to be as low as practical going into expiration.

Max-Pain Theory

The Max-Pain theory holds that market makers will attempt to hold shares (of Apple) to the level that will cause the maximum pain to holders of options – both calls and puts. It is essentially the price level that causes the highest number of aggregate options to expire worthless. This concept has had a hold over Apple for years now. But it’s gotten much worse since the advent of the weekly option.  It used to be that once a month (on the monthly options expiration date), the shares would be forced down to that price level. But now all investors should keep a close eye on the theoretical Max-Pain level each week to get a sense of where the stock will likely close each Friday afternoon. There are occasions when the concept fails, but these are typically few and far between. That tends to happen when sentiment is unusually strong – typically around earnings and product announcements. When sentiment is strong, the buying interest can overtake the market makers desire to hold the shares down. There’s a great website to track this: Travis Lewis is an options expert and has a lot of good information there.

The Battle

If we don’t get follow-through on the rally this week – at least you know why (as Travis often says).