Max Pain Day

There’s an old Wall Street saying that the market will do whatever it takes to cause the most pain to the most investors.

That’s doubly true for options, and there’s even a financial reason behind it.  Long time options players will recognize the phrase “Max Pain” as the price for a stock to close that makes the buyers of options lose the most money possible.

That’s usually right at a strike price, a number that for years was basically an even multiple of $5. After the break I’ll explain why it works, and a couple of options I happen to be involved in that are looking like they will expire exactly on a strike price.

My curiosity is piqued today about whether the effect applies to ETF’s, since they do get traded like stocks, but have a mathematical relationship to dozens (or even hundreds) of “real” stocks, so must be inherently more difficult to manipulate.

First let’s work through the theory.  If you’re Joe Retail, you can’t do this, unless you count guessing that the market makers for the options are going to do it, and you set yourself up to go along for the ride.

Let’s imagine a hot stock that has a lot of action in its options.  It also has quite a few fans and detractors, so its options are very actively traded, both puts and calls.

If the stock has been trading between $17 and $22 a share for the past month or so, chances are good that the $20 options have the largest open interest.  Now let’s imagine that it’s three hours before the close (it is) and that the stock is trading within 20 cents of $20.

Unlike you and me, a market-maker in options does not have to pay to borrow stock to sell short, or pay the full ask when buying.  They also have virtually no transaction costs.  For them, if the call option is trading at 25 cents and the stock is trading at $20.17, it makes sense to buy the stock and sell the call.  If the stock closes above $20, they make eight cents, less their (miniscule) transaction costs.  If the stock closes below $20 but above $19.75, they make money from having sold the call option.

But let’s assume there is also a nickel bid for the put option, even though the stock is trading a bit above $20.  Then it would also make sense to sell the stock short and sell the put.

Net net, the options market maker is short the strangle at $20, but has taken in enough premium to be willing to sell the stock short or go long enough shares to “push” the stock toward a closing price of $20 by hitting the bid or lifting the offer.  At that price, of course, the options market maker keeps all the premium they collected.  Closing out their long or short position is possible if the stock is very active, especially if it has a dedicated cadre of day-traders who want to go home flat on a Friday.

Today I happen to be short some $6 Elan calls and some $13 FAZ calls.  Both stocks were a reasonable distance away from those strike prices yesterday and earlier in the week, but today they are behaving as if there is some powerful gravitational force at exactly the price of my options.

With two and a half hours to go, I’ll see whether the day ends with the stocks within a penny of the strike price.  I think they will.

Especially interesting is how FAZ, a 3x multiplier sector fund, could end up sitting at $13 as though it had been nailed there with Thor’s hammer.

hh

 

OK — The results are in, and ELN nailed it, closing right at $6.  FAZ was at $13.10, so it looks like that can’t be crammed down to the price.  Makes sense.  I bought another slug of the underlying (since my current shares will be called away tomorrow) and immediately sold November $13’s against them.  I’ll net $1.20 per share if they get called awayin five weeks.

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