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Media Don't Understand Apple Options

CHICAGO ( TheStreet) -- Most writers at many of the financial media outlets will tell you that they are writers, not financiers. While at first that may seem like a problem, I have found that most of the time the financial publications relate difficult topics to those in the general public in ways that they are likely to understand.

The only time this agreement doesn't work is when a reporter writes a story without a full understanding of the concept and the editor publishes it with the same lack of understanding.

This cocktail of misinformation recently was published in a piece for Fortune magazine and CNN Money. In the piece, the author makes two wild accusations:
  • That option market-makers are manipulating the stock toward "max pain."
  • That somehow TheStreet is assisting in fixing Apple(AAPL - Get Report) share prices.

Let's start with the first accusation. For a second there I thought the author almost got what was going on when he brought up the large volume that occurred on May 12 at the 340 puts, 345 puts, 345 calls and 350 calls, all in somewhat equal amounts. I was wrong; a person who does not understand options just sees large betting. A trader who watches the timing of the when these strikes went up and in what ratios knows exactly what happened. An institutional customer, almost certainly piggy-backed by every semi-pro retail trader, sold the 340-345-350 iron butterfly.

The customer was hoping for a "pin" on the 345 strike. I understand what he or she did. Over the last several expirations, the strike that traded the largest net volume of calls and puts has been where AAPL has pinned. The issue is that the customers have been winning almost every time. The reason is gamma scalping.

It was the market-makers who were the big losers (and they still may have been the losers on Friday). Hate them or love them, but in Apple, market-makers have been their own worst enemy due to gamma scalping and hedging activities.

"When market-makers are sold premium, they must scalp gamma in order to defend the decay of the long options they own. This is an especially major issue in the weekly options like AAPL where market makers are constantly being sold premium," said Mark Longo, founder of TheOptionsInsider.com. "The issue market-makers are having in the weekly options is that they are being so inundated with premium, they almost stack the deck against themselves."

How? Let me explain.

When I was a market-maker, if someone sold me 250 ATM (at the money) straddles, as the stock would drift away from the strike I would slowly sell or buy stock to keep the position 'delta neutral.' The further AAPL would run from my straddle the more money I would make. At first I would simply trade the stock back and forth as the stock moved toward and away from the straddle strike. That is gamma scalping, the action is meant to counteract theta decay. As options get closer to expiration, gamma and theta begin to increase exponentially.

If I held the straddle going into expiration Thursday and Friday I would be dealing with a large amount of gamma. As the stock ran one direction or another, I would have layered orders that amounted to a sum total of 25,000 shares of stock in either direction above and below the strike. Eventually, I would have 250 100 delta long puts and 25,000 shares of long stock, or 250 100 delta long calls and short 25,000 shares of long stock. The problem for market-makers though is this:

If I had 250 straddles, the DPM (dedicated primary market maker) might have 1,500, other firms might have between 100-2,000 straddles as well. This could add up to market-maker open interest of 5,000-10,000 straddles.

Assuming the number is 10,000, that adds up to layered orders of 1 million shares of AAPL with the intent being to keep the position delta neutral. The layered 1 million shares of AAPL on either side (likely at or around even numbers) produces a large amount of friction for the stock. It basically causes AAPL to bounce off layered orders. Thus the stock pins.

If I look at the AAPL order flow from Thursday, it appears that about 15,000 straddles and iron butterflies were sold to the market-makers on Thursday. This produces about 1.5 million shares of gamma scalping friction around the 345 strike. That is the equivalent of just over 9% of AAPL's average daily volume and close to 15% of the volume that traded on Thursday the 12th.

So then what produced the huge Apple selloff on Friday that caused the stock to pin $340? Again, take a look at the volume on Friday; the 345 straddle traded 24,000 times.

While there is no way to be certain, my guess is that it was produced by a combo of Thursday's straddle-sellers buying back their straddles and a customer buying the 345 straddle to open.

As the stock began to fall from $345 to $344, the short 10,000 or so straddles the market-makers were holding began to have puts that were in the money. To hedge these puts, the traders sold stock, in an action we would call "negative gamma scalping" on the floor. Remember, 10,000 straddles mean that the market- makers have about 1 million or so shares to sell as the stock runs away from $345. Considering that is about 10% of the total volume that traded on Friday May 13, I think we have our answer as to where all the end-of-day volume came from.

By now, hopefully, you can see that the "max pain" was not felt by the retail public or customers, it was actually felt by market-makers who have been crushed week after week by premium sellers.

Then in a final kick in the shins, the one week in which the trade might have worked, the position was seemingly taken away from the market-makers by customer paper just as the stock was running.

In explaining why the author's first argument was off base, paper flow completely nullifies any other cause. Nothing this site or any other financial Web site does has anything to do with how AAPL is hitting max pain points. It is almost certainly caused by customer paper flow from both institutional and retail traders. Anything beyond that is almost certainly coincidental.

Mark Sebastian is COO and Director of Education for Option Pit Option Mentoring. Sebastian is a former market maker on both the Chicago Board Options Exchange and the American Stock Exchange. Along with his role directing the path of education for Option Pit, Mark is currently the Director of Risk for a private hedge fund. He started the popular blog Option911, which is now the Option Pit blog. Sebastian has been published nationally on Yahoo! Finance, is a featured contributor for TheStreet's OptionsProfits, SFO, OptionsZone and is the managing editor for Expiring Monthly: The Option Traders Journal. Mark has a Bachelor's in Science from Villanova University.

On May 19, TheStreet's OptionsProfits is hosting a webinar featuring Tim Hesselsweet. During the presentation, we will address what futures are, term structure and pricing, futures exchanges, equity index, interest rate, currency, commodity and volatility futures and several other components of the product as well as tax treatment and financial modeling. To request a spot for the presentation, please email: jill.malandrino@thestreet.com

OptionsProfits For actionable options trade ideas from a team of experts, visit TheStreet's OptionsProfits now.
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