Market makers are generally short current month at-the-money options (both puts and calls) while the general public is typically (on balance) long those options. Market makers enjoy special margin requirements (or more precisely, a lack of requirements) that allow them to be short options without posting collateral that is required for ordinary investors. If a stock ends up exactly at a strike price at expiration, the market makers can keep their entire gains from both puts and calls that they sold earlier.
Obviously, they have a vested interest to do what they can to manipulate the stock price to end up precisely at a strike price.
For many years, this phenomenon has been tracked by many investors who are looking for a clue as to which strike price the floor will shoot for at expiration. The concept is called the Maximum Pain Indicator.
One free site where you can follow the indicator is Option Pain Here is what they say about it - "On option expiration days, the underlying stock price often moves toward a point that brings maximum loss to option buyers. This specific price, calculated based on all outstanding options in the market, is called Option Pain. Option Pain is a proxy for the stock price manipulation target by the option selling group."
For many years, I followed this indicator each month, and often it was right on the target (last month it was absolutely dead on SPY, for example). However, I have not followed it recently for several reasons. First, the indicator sometimes misses badly, and if you follow it closely, you will probably start placing large bets on its accuracy, and end up losing your shirt. I have preferred taking the position that I have no idea of where the stock will end up, as that is most always the truth.
Second, the indicator works best with individual stocks that are easier for the floor to manipulate than it does for broad-based ETFs like those we use in our portfolios.
Third, the change to strikes at dollar increments reduces the significance of the measure. Back when most strike prices were $5 apart, it was more important to have an idea where the stock was most likely to end up at expiration.
And finally, going into expiration week, the highest total of short puts and calls is almost always at the at-the-money strike price. This doesn't really tell you much except to expect no change in the stock price (which we know is usually not the case).
In spite of all these objections, it remains an interesting concept, and should probably be consulted just in case there is a strong indication that the maximum pain point is a few points higher or lower than the existing stock price.
The bulls were certainly "thankful" this past week as the market moved substantially higher during the holiday shortened week. One week after the market moved to lows not seen since 1997, the Dow and broader market S&P 500 advanced 10.9% and 12%, respectively. It was the best five day stretch (including Friday 11/21) since the 1930's and the first 5 day gain in over a year. However, it must be noted that the rally occurred during a holiday shortened week where volume was extremely light.
Is the market starting the intermediate-term rally that I have been speaking about for the last few weeks? The major indices, namely the S&P 500 moved through some major overhead resistance at the 850 level while in a short-term overbought state. This type of move is typical during the initial stages of an intermediate-term rally. However, the real question is whether or not 850 will act as support if the major market benchmark moves lower over the next week or so. A test and bounce of this strong area of support should be the true test of the sustainability of this rally over the next few weeks.
I have to admit I am some what skeptical of the sharp move this past week in the broader market. Why? The recent move is somewhat similar to the bear-market rally back in October when the market moved substantially higher on relatively light volume only to shed all of those gains in the face of a slew of poor economic reports.
"We're looking at this like not much more than a light-volume, bear market bounce," Ryan Detrick, senior technical analyst at Schaeffer's Investment Research said. "They go away just as quickly as they happen, unfortunately."
Mr. Detrick's statement is just one more reason why I am a bit skeptical of the sustainability of recent 5 day rally. However, I do think if the S&P can hold the 850 level over the next we should see a push higher that carries the market into the New Year.
Government action was definitely the mechanism that drove the market higher throughout the week. A rescue of Citibank was announced. Obama announced his economic team. But, more importantly, the Federal Reserve, in conjunction with the Treasury Department, announced that roughly $800 billion dollars would be used to improve the liquidity of the asset backed securities markets (auto loans, student loans, small business loans) and to purchase direct obligations of government sponsored enterprises and mortgage backed securities. Ultimately, their goal taking such action was to drive interest rates lower which would help to alleviate some of the core problems facing the U.S. economy today.
The announcement worked, if only temporarily, as both the market and mortgage rates reacted favorably. However, the fact that the Libor rate actually moved higher actually moved higher is worrisome. The rate should move lower if confidence is indeed being restored.
On a technical basis, I have to admit I am a bit bearish over the short-term (1-3 day). This is mostly due to the outstanding gains (over 10%) in all of the major market indexes and the skeptical reasons stated in the above paragraphs. However, I do think that if the 850 level can act as a strong area of support over the next week we should expect to see the market experience a rally that carries into the New Year.
The fourth quarter has been absolutely horrible so far the market, but as we move into one the strongest months of the year the market and its participants would not mind if the month of December lived up to its historical billing and finished the month significantly higher. Oftentimes, sharp moves during one month lead to a sharp move in the opposite direction the following month. Only time will tell.
Major Benchmarks
- I have been trading the equity markets with many different strategies for over 40 years. Terry Allen's strategies have been the most consistent money makers for me. I used them during the 2008 melt-down, to earn over 50% annualized return, while all my neighbors were crying about their losses. ~ John Collins