Friday, October 13, 2006
Next Friday's Expiration May Cause Shorts Pain
The interesting thing about this rally is that it was never trusted. Even now with the market breaking out to new highs, there remains a high level of distrust. With options expiration a week from today, that distrust, which has caused aggressive shorts to sell into the strength, is likely to keep prices moving higher. Why? Options expiration generally works against those who have the potential to feel the greatest amount of pain. Right now it is the aggressive shorts that are getting squeezed, so the pain from expiration is likely to be pressed against them.
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Jeff makes a good point. Max pain refers to the propensity for the maximum amount of pain to be applied to the maximum number of options buyers - both put holders and call holders. Generally, however, the group that is holding the largest position, be it calls or puts, represents the group that contract writers will go after the hardest if they are able. Contract writers make the most money when contracts expire out of the money. Our observation was that at least up until late last week that a large group of traders had been agressively shorting the market. This group has continued to experience pain as the market rides a wall of worry higher. Call writers may indeed feel some pain this week, but our hypothesis - at least at the time of the post - was that put buyers would continue to feel the same pain they have been enduring over and over again recently right up through this week's expiration. At this point it's just a hypothesis. Today and tomorrow should be telling.
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