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Be afraid, be a teeny-weeny bit afraid
June 15, 2000
UK-iNvest.com
There's a witching about. But unlike last year, this one has little to do
with a camera crew going astray in Maryland, let alone the Burkitsville
murders of 1940-41.
No, this "witching" is about the confluence of several futures and options
contract expiries on Friday, both here and in the US. And dealers say that
will distort trading over the remainder of this week.
"If it is a low volume day and unless there is some deep fundamental news
flow to change its mood," said one dealer, "the market will be open to
manipulation by the large investment banks to push stocks close to their
strike price -- and even through it. That is not the sort of thing they will
admit to, but that is what they do."
How it works
What does it all mean? (If you already know, skip to the next section.)
There is a strong correlation between futures and options, and the assets
they are based on. When they diverge, bigger players exploit the anomaly
(and make money) in a process called arbitrage. All things being equal, the
futures contract will expire at the price of the underlying security.
The options, meanwhile, will be in-the-money, out-of-the-money or
at-the-money, depending on where the strike price is in relation to the
closing price of the futures or cash products upon which they are based. OK,
so what is the strike price? The strike price, basically, is the level at
which you, as the holder of an option, have the right to buy (if a call
option) or sell (if a put option) the underlying shares or index. So, if the
Nasdaq at the time of expiry is at 4,000 and you are the proud owner of a
Chicago Mercantile Exchange 4,050 put, then you will be in-the-money to the
tune of 50 points. Times that by the contract size, of $100, and you get
your gross return, minus any transaction costs. A 4,050 call option, on the
other hand, would have expired worthless, precisely because it was
out-of-the-money.
It is also important to appreciate that the vast majority of futures and
option contracts are held until expiry or close to expiry. The upshot is
there can be considerable latent pressure among institutional investors in
the final week of activity to ensure options either fall in or out of the
money, depending on where their interests lie.
The third Friday of the month
The third Friday of the month, not least in the key quarterly months of
June, September, December and March, is especially congested with contract
expiries. But strictly speaking this Friday is not a "triple witching day"
in the traditional, US sense of the phrase. It is the last trading day for
individual stock and stock index options traded on American Stock Exchange,
Chicago Board Options Exchange, Pacific Exchange and Philadelphia Exchange
(as well as on the CME), sure, but the CME's futures contract based on the
S&P 500, Nasdaq, and Russell 2000 indices actually expire on Thursday.
However, it is not just a US thing. Over here in the UK, Friday is also a
significant day for Liffe options and futures based on the FTSE 100 and 250,
which expire at 10.30am. Liffe's European family of indices also expire at
12 o'clock.
Individual UK stock options, though, do not expire until next Wednesday.
You know it's coming but.
So what can we expect to see? In truth, unless one is privy to the bigger
banks' trading books, it is exceedingly difficult to say. It's like watching
England or Spain: you know it's coming, but you don't how they'll be
eliminated from a major championship (sorry, it's the mood I'm in).
Still, option interest data, available from most futures exchanges online,
can provide clues. It is reasonable to say, for example, that institutional
investors who have sold call options with a strike price of 6,700, a level
at which open interest on the Liffe FTSE 100 June contract really begins to
build up, have every reason to ensure that the FTSE does not reach that
level by 10:30 on Friday. And vice versa.
It is therefore fair to assume that a lot of attention will be focused on
top weight Vodafone Airtouch (VOD). Indeed, Vodafone boasts the most open
interest of all the individual stock options listed by Liffe -- there were
more than 200,000 contracts open at the close of business yesterday, nearly
one-quarter of Liffe's total.
It is also interesting to note that there has been a big pick up in
options-related business in recent days involving BSkyB (BSY). With tomorrow
being the Premier League's deadline for the award of televised football
rights, there is everything still to pay for and that is reflected in the
high number of options, both put and call, that are out of the money.
Extra volatility
"You do find on, and close to, the expiry day that you could get perverse
movements in the market that are either out of line with the fundamentals
and mood of the day," said a seasoned London trader. If we could anticipate
how this might be played out we would all be millionaires. What is hard to
deny, though, is that this introduces an extra layer of short-term
volatility in the market place -- happy days if you are an options
specialist
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