In Reply To:
A 1-day History of AAPL Share Price Fluctuation

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By RodgerRafter
July 19, 2002

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I've read your posts regarding max-pain over the past months, and I think that you are making one major oversight. While open interest often gives and indication of the number of options written by major market makers, it can also indicate that a large number of contracts have been purchased by those market makers as a result of other parties selling the options.

The 3 million or so shares worth of July 15 Puts traded a month ago may have been a sucker bet like you assumed, but other possibilities also arise:

1. A large institutional investor may have thought the price of the puts was too high and then sold 3 million shares worth of puts as a way of pocketing about $1 million in a month. This would be a high risk move that would backfire if Apple fell much below $15, but it didn't seem likely at the time.

2. Apple may have tried to pocket around $1 million, risk free, figuring that if the stock really dropped all the way to $15 or lower, they'd just buy back 3 million shares at $15.

3. A large short may have sold covered puts to increase the chances of making a small gain, while decreasing the chances of making an especially large one.

If number 1 or 3 were true, then the market maker who purchased the options would have a big incentive to drag the price down for expiry. A speculating counterparty would be more inclined to take a loss on the options by buying back the contracts than he would be to tie up $45 million in Apple shares.

If number 2 is true, then there isn't as much to be gained by driving the price down. There would be a short term gain on the options, but then the market maker would be saddled with a 3 million share short interest (at a basis of about $14.70) that could be difficult to get out of profitably in the future.

If your original suspicion was true, however, and Wall St. did the writing on the contracts then it won't matter whether Apple trades at $15 or $50 tomorrow, so long as the options lose all of their value.

It'll be fun to watch both the options and share volume activity tomorrow to try and guess what was behind it.

Before Tuesday, I'd have been inclined to guess with you that some large mutual fund was buying the puts in order to protect them against a big loss (but not that some large speculator was making a high risk bet). However, after listening to Salomon's Gardiner with his unusually hostile tone during the conference call, then watching him severely distort the effect of the channel numbers in issuing his downgrade, I'm inclined to the [belief] that SSB is more likely to be the big put holder than any of the other big market makers are to be the big put writers.

I was a big champion of Max-Pain theory back in 1998 and 1999, when the market was booming and scores of clueless small investors were trying to get rich quick on options. Now, however, I believe that covered call and put writing has grown in prominence to the point that Max-Pain doesn't give reliable predictions for options expiry.

Nevertheless I appreciate your keeping tabs on options activity and reporting your findings and theories here.


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