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. 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 http://www.optionpain.com/MaxPain/Max-Pain.php. 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. 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.
In case you missed the earlier videos, you can catch the first one here - Why Stock Options are Better Than Mutual Funds. Click here for the second video - How to Create a Conservative Options Portfolio. And here for the third video - How to Use Options to Invest in Gold.
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Terry
It was a fairly slow week for the market, at least on the news front. However, this did not deter the market as it once again rallied this week and as a result the Dow, Nasdaq and S&P hit fresh 52-week highs. The largest portion of the advance occurred Monday and the gain was mostly driven by the large-caps. The climb higher was attributed to the sinking U.S. dollar.
The U.S. Dollar Index lost 1.1% and hit a fresh 52-wee low. The dollar eventually hit 74.77 mid-week which was its lowest level since August 2008. As a result, Gold advanced and hit an all-time high, which is typical when the dollar slides. Gold, which has no liabilities associated with it, is looked at as a safe place for investors to insulate their wealth from the tax that comes with monetary inflation.
"We believe the outlook for gold prices remains bullish," analysts at Deutsche Bank wrote in a research report. "However, the speed of the appreciation over the past few weeks may be difficult to sustain without a further weakening in the U.S. dollar."
The S&P 500 (SPY), Dow (DIA), Nasdaq 100 (QQQQ) and Russell (IWM) advanced 2.3%, 2.5%, 2.6% and 1.0%, respectively. For the year, the S&P 500 is up 21.1%, the Dow has advanced 17.0% and the Nasdaq is leading the way with a 37.5% gain.
The rest of the week was slow on the economic front. Third quarter earnings have winded down. However, next week brings a plethora of economic news that should help drive the market in a directional manner. The calendar includes Retail Sales on Monday, Industrial Production on Tuesday, CPI and Housing Starts/Building Permits on Wednesday and Existing Home Sales on Friday.
On the technical front, the large-cap Dow (DIA) and tech-heavy NASDAQ 100 (QQQQ) have pushed into a short-term overbought state. The S&P 500 (SPY) is also nearing an overbought state so I expect to see a short-term decline over the next few days.
However, expiration week is known for being bullish so I would not be surprised to see a short-term decline early net week followed by an advance that carries into option expiration. The S&P (SPX) is still well above what has been a strong (and pivotal) level of 1020 so if the index does happen to decline early next week I will keep an eye on 1020.
As I stated last week, the much hyped and talked about stock market correction has yet to materialize. I am beginning to wonder if it will as we continue to see a recovery in productivity. Again, could we witness a jobless recovery? In a consumer driven economy that might be tough but we shall see soon enough, right? One thing is certain, the S&P 500 is only 0.4% from its recent high and up more than 60% since the low set in March.
Andy
Overbought/Oversold as of November 14, 2009
Major Benchmarks