This Market's Efficient... At Fleecing Options Traders

For decades, one of the central beliefs concerning financial markets is that "price is right," meaning that markets are efficient at discounting future growth and economic realities. The extension of this ideology is that whatever the market prices a security at, that's fair value. Price is right and you can't argue with price.

Whoever came up with this, obviously observe options expiration week.

For years, options expiration week has been Wall Street's favorite time to gun the market so they can close their options trades in the black. For this reason, the market always puts on a show during options expiration week, moving sharply one direction then the next to hit price points where open interest on various calls and puts are highest.

This final point is key: the volatility from options expiration week largely depends on where the market is heading prior. Here's a three-month chart of the S&P 500's action for July and August 2009. I've bookmarked the three respective options expiration weeks with red lines:

In July, the S&P 500 was cooling dramatically after its explosive rally from March-June '09. In fact, the S&P 500 had just broken down below its 50-DMA for the first time since the rally began. So put interest was growing as traders began betting on another collapse. Consequently, options expiration week for July resulted in a massive ramp job taking the puts to the cleaners.

The same thing happened in August. At that point the rally started in July was cooling and looked ready to reverse. Indeed, stocks had been trading sideways for two weeks. Again, investors were starting to place bets on a collapse. And once again, the puts got absolutely shredded on options expiration week. Ironically, the market DID reverse strongly soon after expiration week was over.

By the time the autumn rolled around, bullishness was climbing higher and higher. Stocks had posted six months straight of gains and every hint of a collapse had been met with a rapid reversal and another leg up. Because of this, call interests were rising (meaning investors were betting on greater gains for stocks).

As a result of this, options expiration week began to feature a ramp job to kill the puts, then a sharp reversal to crush the calls. You can see this clearly in both September and October's options expiration weeks (bookmarked by red lines).

By the time November and December rolled around, bullishness was approaching 2007 levels. So those months' options expirations were largely about taking the calls to the cleaners with a massive collapse.

Finally, once we got to January bullishness was back to 2007 levels. Stocks continued to slog higher on no volume so options expiration was about eviscerating the calls (with a decent ramp to slam any bears who still dared to buy puts).

Then starts the Greece debacle. Stocks enter a free fall, undoing three months' of gains in a little over two weeks. So what do we get for February's options expiration week? RAMP JOB. As in MEGA ramp job: in five days (I'm counting Friday because the ramp job obviously started then), Wall Street took the S&P 500 from 1,070 to 1,110, a gain of 3.7%. That is an extraordinary weekly gain for stocks, annualized it comes to nearly 200%.

For those of you who are swing traders, take note, options expiration week is one of the most volatile gamed weeks in market action. If you're interested in trying to play the game, you might consider looking at SPY open interest on calls and puts the week before options expiration hits.

Good Investing!

Graham Summers