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Technology Stocks : DELL Bear Thread -- Ignore unavailable to you. Want to Upgrade?

To: Moominoid who wrote (670)	5/16/1998 7:27:00 AM
From: jjs_ynot	Respond to of 2578

The option open interest will tend to drive the price to a point where the cost of the open interest is in equilibrium. This is driven by market forces which are mostly manifested in Market Maker Hedging. The following is a discussion of MM hedging strategies. The hedging strategy of a MM is a complex topic. I will try to relate to you what I have come to understand about this topic. I will also include a discussion of alternative option strategies used by large traders to close out an option position which can also impact the price of the underlying stock. If you sell a CALL option on expiration day, the MM is to take the other side of this transaction. So the MM ends up purchasing the option and then hedging by selling stock. Now in a different situation, where the MM finds himself in the position of having to sell allot of CALL options short to meet the demand for the CALL option by buyers of a relatively illiquid option, then the MM may hedge against changes in the options price itself by purchasing an option of another series to offset the options that he sold short. This means that for instance the MM will purchase a CALL at different strike price but same expiration date to create a credit spread. But then this type of hedging is not related to expiration day activity. This is just a way fo the MM in the regular course of business to manage the risks involved in a open short position in an option that he does not think will be able to be covered in a timely manner by purchasing the same option back from another trader. As far as the credit spread is concerned, depending on the strike prices of the options in the spread, the MM has the potential of losing some money. But this limits his downside risk at the same time limiting his cost on this transaction where in this case he can net a small profit. The MM as you have mentioned can also hedge a standing short position in an option through the purchase of stock, but it is not that simple. All he would be doing is converting naked CALL writing to covered CALL writing. This still does not buffer him well from price changes in the underlying stock. This is only a partial hedge with potentially unlimited downside risk. Even if the CALL option never gets exercised then he is left with the stock and any losses that he may have incurred holding the stock. So he would have to follow up through the purchase of a PUT option converting the covered position into a synthetic position. This would be a complete hedge. However, legging into a synthetic position can be difficult and even not worthwhile for the MM to pursue. The alternative is the spread mentioned in the previous paragraph. The type of risk management taken by the MM through spreads and synthetics I am still in the process of learning about. So I would appreciate for anyone familiar with spreads and synthetics to please provide me with feedback. I also want to mention that the MM does not normally provide himself with complete hedges. He apparently sets himself up with a "partial" hedge in anticipation of future trading activity that can help him "complete" the effect of his hedge. This makes the MM vulnerable to large unpredictable price changes in the underlying stock like gaps. On another related topic, when a trader has a large open position in an option that needs to be quickly sold, it may not be in the best interest to the trader to sell the option. For example, if the option traded in a relatively illiquid market, as that trader sold his options, the selling of the option by the trader would drive the premium of the option driven down which would work against the trader's efforts. Instead of an outright sale of the option, the trader can "blow out" of his position by in the instance of the CALL option selling the stock short. This is assuming that the stock is liquid for this type of transaction. Once this is done, it is a simple matter of exercising the option and using the stock to cover the short position in the stock. This the trader will have time to complete free of risk due to his hedged position. So for instance, if you see a very large open CALL interest that was accumulated over a pending news report that may be from one or very few interests, when the news report came out, not only will this news event impact the price of the stock, but the "blowing out" of the CALL holders' position on this option can also impact the price of the stock. Furthermore, if this large open position in the CALL option was accumulated by many buying interests, then their selling will place downward pressure on the premium of the option. Assuming the group of speculators are not closing their option positions in an intelligent way which can be the case in anything that concerns the public and news events, the premium of the option can be driven down far enough for professionals to step in, purchase the options that the public is selling, and perform an arbitrage action. Depending on the type of arbitrage action involved, and assuming this is an in-the-money option, this action on the floor professionals part can place downward pressure on the price of the underlying stock too. As you see, the actions on the part of different types of traders who are trading different kinds of instruments can be connecting in ways that are not readily apparent. This is one aspect of the market that makes it interesting.

To: Moominoid who wrote (670)	5/16/1998 8:59:00 AM
From: Ben Antanaitis	Respond to of 2578

David, At the bottom of the Options Analysis table, there is a link that takes you to a worked out explanation of how the Max-Pain analysis is done and what I am trying to track. I think that it gives you a very clear idea of one of the dynamics in action around a stock. When the primary forces, eg news, momentum, Greenspan, Kurlak, etc are not driving a stocks price , the second order effect of Max-Pain is at work 'attracting' the stocks price on expiry day. This gives a trader/investor one more clue where the price of a stock may be on one specific day in the month. DELL right now is caught up in a huge momentum wave, but so was LU last month. But momentum does not last forever....... Ben A. PS the previous note in the thread gives a good description of the techniques used to 'help' theprice of the stock gravitate to a specific price.