Options expiry imbalances could move bonds

[steven poser <swp@xxxxxxxxxx>]

July options on the Sep bond futures expire tomorrow. There are some
fairly significant imbalances in open interest at various strikes which
could cause some temporary spikes in prices as traders delta hedge their
positions in the futures markets. And, after expiry, I think at 1PM NY
time tomorrow, can only be hedged in futures directly. This analysis can
of course be extended to any expiring options contract.

Here are the outstanding puts and calls for the expiring July series as
of yesterday's close:

Strike   Puts    Calls
======   ====    =====
119     57435    <2000
120     40015    12216
121     34555    31447
122     66414    29128
123     16704    28209
124      3709    26000
125     <1000    14720
126     <1000    <2000

Current price is near 122-22.

Now what happens when there are imbalances? The guys that are short the
options have a problem, while those that are long could really care
less. They can either take on the futures position or close out the
options. The guys who are short will probably delta hedge their
position, but as prices go against them, the delta keeps rising forcing
them to sell or buy more futures to remain hedged. For example, imagine
you are short 10,000 123 calls. The current delta is 0.29. If prices
rise to 123-02 by today, delta rises to 0.54 meaning you have to BUY an
additional 2500 contracts to stay hedged on your call sale.

So, let's look at the imbalances. There is a fairly decent imablance at
123 strikes in favor of calls at 38K to just under 17K, so as prices
rise to and above 123, the short call players will be buying to hedge
their positions. There is also a large imblance at 124, so any very
bullish news for bonds could cause a large options induced rally. There
are not many options outstanding at 125 and above.

There is a large imbalance at 122 in favor of puts, so a drop below or
to near 122 could cause significant problems. Luckily,there it is very
balanced at 121 so prices would not spiral lower due to options expiry.
At strikes of 120 and below, which would take a major bond market
calmity, prices would be pressured lower by options expiry.