There is no way for the option specialist to "control" stocks. If somebody were to really think about this, I think they would find this an absurd thought. The market makers of options are in the game of making a market in options, not speculating in stocks. IMO the market maker of options needs to hedge his poistion in the underlying stock as the result of their exersize of options on option expiration day.
Lets say you were an option market maker. Here it is expiration Friday. Lets refer to CALL options for the purpose of this post. There are still a significant amount of open interest in particular CALL options that you make a market in. Since "out of the money" options are worthless on this day, we must be talking about "in the money" options. On this day as an option holder, you must exersize the options that expire on this day, or trade them. Guess who takes the other side of this trade? The market maker in that option. Where do you think all of these "in the money" options that do have intrinsic value "disappear" to by the end of the day? Some are exersized by their holder. The rest are traded off which end up in the market maker's hands. Guess what he does with this option that he just spent his money on? He exersizes the option. This is how he derives the intrinsic value of the option in order to cover his cost.
There are two issues here that the market maker has to deal with when it comes to "retiring" (closing out) the outstanding options that are traded to him. One is that he gets delivery on the stock the following week. However, the stock can change price in that period of time. He is not there to speculate on stock. So he needs to hedge his position by simultaneously shorting stock as he exersizes the option. This locks in the value of the underlying stock at the time the option was exersized, which is what the option's intrinsic value is based on. In this way, he does not lose any money between the time of the exersize and the time the stock is delivered to him for him to sell. At this point, you may ask why the option holders do not all exersize their "in the money" option. This may not be to their advantage. They would incur unecissary two way comission costs on the stock which is particularily true for option holders who trade off of the floor. Also, many if not most option holder trade options. They are not interested in the stock itself.
Shorting stock has the side effect of dropping the price of the stock, particularily if there ends up being enough stock shorted. In other words, a large open interest in a CALL option when closed out by the specialist through an exersize results in driving the price of the stock down by the MMs hedging efforts. Now the MM or anyone else for that matter cannot trade worthless options. If the stock price drops below the strike price of this option in question, then no more trades will occur on this option. So the closing out of this option by the market maker will continue until his hedging efforts has driven the price of the stock down to the option's strike price. Does this sound familliar to anyone here?
Steve, correct me if I am wrong, but in this situation there can be "slippage" between the exersize of the option and the short of the stock. Also there is his cost in shorting the stock, and then replacing the same stock the following week with the shares delivered by the CALL option writer. The market maker on options expiration day discounts the value of the option to below its intrinsic value to guard against this . So this is where I think this discount value that Steve has noticed comes into play. The discounting has an added positive effect of enouraging arbitration on that option by others who will effectively take on the role of the "market maker who is closing out options" by purchasing the option and exersizing it to gain as a profit the discount on the option. So the discounting of the option on options expiration day also encourages arbitage which helps the MM of the option handle options expiration day on options with a large open interest. This is because the MM does not want to get stuck with these options at the end of the day.
Also, this shorting effect can impact the market maker or specialist in the underlying stock. So if the market maker in the option works for the same company that has a MM or specialist in the underlying security, I am sure they will be talking to each other on options expieration day, particularily if allot of shorting of stock is anticipated by the MM of the option. Also, since the stock is actually delivered the following week, the option holder who does exersize may then sell off that following Monday or Tuesday. This can have a short term impact on the stock if many option holders choose to take this course on options expiration day.
Volitility also can be introduced into the price of the underlying stock of this option *before* options expiration day. This is through arbitage action on the option. The option right near expiration has no time premium. However, active trades done on an option at that time can temporarily generate a disparity between the pice of the option and the underlying stock, or create a disparity between the CALL option and its associated PUT option. So arbitageurs will step in here to profit fromthe different by purchasing the option and exersizing it. Their very low costs allow them to profit from this.
Comments or feedback anyone?
Bob Graham |
