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Minyan Mailbag: Options



Note: Our goal in Minyanville is to remove intimidation from the financial markets and encourage an interactive dialogue among the Minyanship. We share this next column with that very intent.

Prof. Succo,

Could you comment on something I read in a Financial Sense article.

It has to do with a potential market meltdown due to the fact that there are enormous levels of put sellers at various levels of the S&P500. Specifically, there appears to approx. $10 billion of volume in dollars at the 1175 level, which coincides with the 200 day moving average. The bet by these huge put sellers is that the S&P500 will hold this level. However, if it does not, they would be forced to sell the S&P500 short to hedge their short put exposure.

Minyan Steve S


First of all remember for every seller of puts there is a buyer; these two will normally take action counter to each other when an option starts to go itm)" target=_blank>in the money. When one panics, the other is there to re-hedge their position and most of the time offset that panic. It is only when the sellers as a group have a much different time horizon and risk profile than the buyers that things can get crazy.

Of course it is impossible to determine this given the varied nature and lack of information of the participants. But we can gather alot of information from price and open interest.

As you point out the open interest in June is rather large: it is about 20% larger thant he open interest from last year. Secondly, the price of these index options is much cheaper than last year. We can guess that "smarter" hedgers were not buying puts last year because of price, but may be this year. So right off we can guess that the marginal buyers are not stupid.

The lower price (out of the money put options are relatively cheap given the recent volatility of the market, but not nearly as cheap as they were in 1987 where the crash was actually caused by the technical factors of huge open interest combined with very cheap options. I have explained before the role that portfolio insurance, synthetic options, played in this process) causes a higher gamma. This higher gamma can create problems when the puts go in the money: traders short options must re-hedge more aggressively when options are cheaper and have a higher gamma.

I would say on a scale of one to ten the combination of higher open interest and lower option prices (higher gamma) put the risk factors for a "market meltdown" due to these technical factors is a six or seven. In 1987 they were a 10.

Prof. Succo

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