Ho John Lee’s Weblog

Here’s a graph of the open interest in Sep07 SPX options. Unlike your typical equity option which settle based on opex Friday’s close, most index options settle based on the opening value of the S&P 500 index on expiration Friday.

This leads to interesting dynamics like last month, when Ben Bernanke cut the discount rate just before the market open on Friday. A lot of fund managers went to bed Thursday with good looking option positions that got crushed Friday morning when S&P 500 components gapped up at the open.

Thursday SPX cash closed at 1518.75. I come up with around 1490 for max pain. (”Max Pain” is the settlement value that will result in the lowest aggregate value for the open contracts at expiration.) This, and the big run up since the unexpected 50bps rate cut on Thursday, suggest a lower bias going into tomorrow’s open, which we would see in the futures. ESZ7 (December S&P futures contract) closed Thursday at 1531.75.

Part of what makes the index options settlement interesting is that the settlement value is based on the opening trades in each of the components, and they don’t all open at the same time. It takes a huge amount of money to move the entire market around, but you can jack the futures up or down, along with selected issues in thin premarket sessions to induce a higher or lower opening cross in your preferred direction. I don’t generally attempt to take a trade based on max pain alone, but it can be useful to know where some pricing anomalies may occur. On SPX, the institutional-sized interest tends to fall at multiples of 25, i.e. 1475, 1500, 1525, which is easily visible on the graph. If the opening price gets moved to a strike, there can also be an opportunity to fade the gap, as the trade gets unwound.

The rate cut on Tuesday resulted in a lot of excitement and probably an overdone level of buying. So there are some other reasons we might see prices come in on Friday. However, it looks like the “Bin Laden Trade” (many, many Sep07 SPX 700 puts) isn’t going to expire in the money.

This entry was posted on Thursday, September 20th, 2007 at 9:11 pm and is filed under Finance/Investing, Front Page. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.