Thursday, April 15, 2010

Price is never right

This is option Expiration week. All equity, ETF and Index options expire tomorrow. The expiration is on the third Friday of each month. CBOE has a ton of information on options. Here is a link for 2010 expiration calendar. There are two types of options calls and puts. A call option gives the holder a right to buy the underlying security and a put option gives the right to sell. These are marketed as insurance. Lets say one owns a stock that closed at $595 and their earnings are coming out tonight. They are not sure if the stock is going to make it. They may want buy the 590 puts for about $10. If they report very good earnings and the stock jumps $35 then one spent $10 and captured rest of the move. If they report bad earning and stock get hit to 550 they will be covered for 40 of the 45 dollar move from 595 by this put insurance. It limits the loss to $15 ($10 premium and $5 out of money) and leaves the upside to all but $10 premium. CBOE has better write up. Premium is highest at the beginning of the option period (e.g. one will pay the highest premium for May option on Monday) and lowest on the day they expire. It is primarily because you get to coverage for a month in first case and only one day in the later. My experience is there are a lot of speculators in the last week of the option. Like in Goog's case if one bets $10 and the stock gets hit to 550 one can make 45 less costs (usually less than 25cents a share + premium + out of money amount). That is pure speculation. Most of the contracts that are open are written by professionals and they are naked meaning they back it up with margin required money and not actual security. Some people believe that leads to an incentive to manipulate. If I am open 5million shares equivalent in puts at 580 then I may manipulate to keep it above 580, for every dollar below 580 I loose 5 million. Same on call if a large open interest exists at say 590 then there may be a reason to keep the price below 590. Here comes Max pain calculator. It is the price at which the equity has to close to cause least pain to professionals. It is available at The big problem is the CBOE only provides 2 day old data on open interest. So the max pain results are 2 days old and that is a millennium in options market. The right way to use it is start looking at Maxpain value for the security every day from Monday after option expiration and plot this data and underlying security data (offset backwards by 2 days) Then one can get a better projected max pain price. Just looking at the snap shot the day before option expires is very misleading.
Fas went out of the envelope and back into it closed very negatively. Our DMRM is at 115.40. I didn't short at the envelope having been just burnt yesterday. Google's report wasn't spectacular but BofA may make up some and leave the indices flat. I will unload some more of my longs but not all of it. That only comes at 1191 on spx. 

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