HOW DOES THAT STOCK CLOSE...(PART II)
This was emailed to me by someone. I don't know if it is accurate as to author, but I assume it is, so I've included the (c). (Mr. Cramer's deal is at: thestreet.com
Wrong! Tactics and Strategies: Cramer
on Expiration Week Fun and Games
By James J. Cramer
12/17/97 2:14 PM ET
(Jim Cramer notes: This piece may be over some heads,
but I wanted to get it out because of the number of
customer requests to explain the role of options in moving
stocks in expiration week.)
The ugly, pimpled face of expiration stares me in the face.
There's IBM at $105, as it should be. Schlumberger
hangin' at $80. Same with Pfizer at $75. Looks like another
case of options boys starting their Friday fun a little early,
playing pin the strike on the common.
How does this game work? Why do stocks gravitate to the
strike? Okay, let's take IBM. As of this writing IBM stands at
104.5. The December 105 puts are at 1.25, the December
105 calls at 7/8.
Let's say you are long that call. That doesn't look like too
good a gamble at this writing. So you bang it out. Who buys
it? Typically a market maker. Maybe he shorted the call to
you and he is bringing his short in. Maybe he takes the call
and waits for a plus tick for IBM and he shorts IBM against
it. Risk? The price of the call. Reward? If IBM gets bombed,
you've got a good trade.
In the meantime, the guy with the put is nervous too. He
wants to unload that put while it still has some worth. He
knows that intrinsically, with two days to go, he's got one
awful wasting asset, worth about a half buck. So he blows
out of the darn thing.
The call seller puts downward pressure on the stock. The
put seller puts upward pressure (if you buy that put, you can
go buy common and get a free shot above 105. Risk? The
price of the put.).
Guys like me (I don't do this, but I have) see all of this
activity. We start banging out both the puts and the calls.
We get short both of them. We smell 105 on the stock
Friday. You can short calls and puts without upticks. With
unlimited capital, you can stand there all day selling these
two instruments. You, too, are putting pressure on the stock
to close at the strike. Why? Because the natural buyer of
your call sells common stock to get the free short below 105
and the natural buyer of your put buys common stock to get
the free long above 105. (You can take it one step further
and sell the call against the common to lock in a return. This
is difficult to grasp, but not stupid, if the call pumps. This
additional strategy is extremely sophisticated risk/reward
stuff that is dynamite if you pay no commish, like the market
makers, but not that cost effective if you pay standard
commissions.)
These trades get done hundreds of thousands of times. Writ
large they amount to heavy "arbitrage" pressure to pin IBM
to 105, where the naked seller of the puts and calls "wins"!
Can you do this at home? Not on your life. Let's say IBM
preannounces a bad quarter tonight. Your naked put sale will
ruin a year's worth of profits. (That's why I don't do this
anymore.) Your naked call sell? How about a big buy
imbalance ramp on Friday that takes IBM to 110?
Then why did I used to short the puts and calls? Sometimes
I am pretty fearless (the Trading Goddess says
"reckless"). Sometimes I could do it enough times to handle
the occasional shortfall. And other times, I guess I just
wanted to take advantage of the construct. I almost always
made money doing this. But it is not for the squeamish.
I don't mention this as a money-making strategy. I mention it
as a reason why stocks go out at the strike. Use it anyway
you want, but be forewarned that selling puts naked put a
guy out of business this year, a guy who sold a lot of books
about his great record and the market. Don't let it happen to
you.
James J. Cramer is manager of a hedge fund and
co-chairman of TheStreet.com. Under no circumstances
does the information in this column represent a
recommendation to buy or sell stocks. Mr. Cramer's writings
provide insights into the dynamics of money management
and are not a solicitation for transactions. While he cannot
provide investment advice or recommendations, he
welcomes your feedback, emailed to Jjc@Jjcramerco.com.
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