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Technology Stocks : IFMX - Investment Discussion -- Ignore unavailable to you. Want to Upgrade?

To: R Stevens who wrote (10747)	5/9/1998 2:38:00 PM
From: Robert Graham	Read Replies (1) \| Respond to of 14631

Many of the CALL options that are available are traded by people with no intention of assuming a long position in the underlying stock, and in the case of PUTs, the trader has no interest in selling stock. That is why many if not most options at expiration end up in the hands of the market maker. The options that are traded on that day are those that are in-the-money and therefore have intrinsic value, which happens to be the value that they are traded on (aside from a fractional difference to the MMs advantage). This value is realized when the MM exersizes the option. However, when the MM takes on these the in-the-money options, he needs to hedge his position to guard against changes in price of the underlying stock which would change the value of the in-the-money option. The MM does this by buying or selling stock. If the option is a CALL option, the MM hedges by selling stock. If it is a PUT options, the MM purchases stock. Both actions lock in the profits to the MM in their respective cases. If an option has a large open interest going into expiration, the effect of this hedging action can be more pronounced on the price of the stock. Since only options are traded that are in-the-money, this hedging action will not occur when the stock price has reached the strike price of the option. That is why CALL options with a large open interest going into expiration tend to place downward pressure on the stock to its strike price, and the reverse is true for PUT options that have a large open interest. Lets take this a step further. Imagine if you were the MM and saw a comparatively large open interest in a particular option. You do not want to get stuck with a last minute inflow of options to be hedged at the last minute at the close of the trading day. This is where it will become risky do to the volatility of the underlying stock that this can help cause. So what do you do? One approach is to encourage others to participate in the MM function of expiration so to have them take on this risk. You do this be selling the option at a discount with respect to its intrinsic value. This potential profit will encourage other traders to perform an arbitage (sp) by purchasing the option, selling stock short to lock in the small profit, and exersize the option for the stock to be sold at a later time. So it is not uncommon to find options on expiration day selling below their intrinsic value. However, only floor traders who operate with virtually non-existent commission costs can take advantage of this situation. Also, there are other games that traders and hedge funds perform during options expiration week that helps provide volitile price action in the underlying stock. I will into get into any details here, but this is an area that I am currently learnings about. However, I will say this has to do with either the "cheap" price on certain options during this expiration week, and other comparative price inefficiencies of options that can happen during this expiration week which can cause arbitage effects on the underlying price of the stock. Many traders think the price swings in a stock is the MM manipulating the price of the stock to shake out any option holders. In reality, much of it is likely to be the result of arbitage plays of one kind or another. And if the stock is part of the DJIA or even the S&P 500, I suspect this effect can be magnified, just as program trading can influence the short term price of these stocks. Comments anyone? Bob Graham