Well, that was certainly a week.
Much to my dismay, we saw the VIX pop right ahead of August expirations, and the market took a little bit of a beat-down, though it did manage to recover a little bit ahead of the close on Friday.
But in addition to watching and trading volatility (to find out more about my volatility trades, click here), I was also keeping a close eye on a handful of equities …
Specifically, this mega-cap tech stock that was seeing huge – huge! – action in the pits at the beginning of the week …
I’m talking about over 1.7 million contracts traded …
In just four strikes …
In options that expired this Friday!
In fact, I think all of this action in the pits triggered a reverse squeeze …
Here’s what happened.
Options traders were going bananas on Apple (Ticker: AAPL) calls in the beginning of the week – specifically, the August-dated 149, 150, 152.50, and 155-strike calls.
In these four contracts alone, AAPL saw over 1.7 million contracts cross the tape during the first two trading sessions of the week!
That’s a huge demand for those options – exceptional, really.
Now, here is why that’s important.
When you buy or sell an option, you, personally, aren’t buying or selling with Joe Schmoe out in Arkansas – you’re buying or selling from a market maker.
Obviously, these market makers aren’t working charitably, and they’re figuring in a little bit of profit for themselves in the transaction.
They also need to limit their potential losses, in the form of hedging.
So, for example, if you buy 10 contracts of 150-strike AAPL puts, the market maker doesn’t want to be in a position where AAPL shoots to $175, and now they’ve got to buy 1,000 shares of AAPL at $175 to fulfill their obligation to you when you exercise your calls.
But they also don’t want to outright buy 1,000 shares of AAPL every time someone buys 10 call contracts – after all, all contracts are not created equal, and some calls are more likely to finish in-the-money than others.
If you read my column on Monday, you may be thinking “Hey Mark, does this have something to do with those Greeks we talked about?”
To which I would say: Yes! Yes it does!
Market makers base their hedging on an option’s delta.
If you didn’t read Monday’s Greeks explainer, the delta of an option reflects how much the price of an option will change for every $1 change in the underlying.
At-the-money (ATM) options typically have a delta of 0.5 (or -0.5 for puts), with the delta increasing the further in-the-money (ITM) the option is, or decreasing as an option gets further out-of-the-money (OTM).
To illustrate, let’s say you paid $2 to buy a call option with a delta of 0.5 on Stock XYZ.
If Stock XYZ rises $1, your call option should now be worth $2.50.
An options delta can also be used as a back-of-the-napkin estimate of the likelihood that an option will finish in-the-money. So an option with a delta of 0.5 has a roughly 50% chance of ending up in the money.
Still with me?
Now, an option’s gamma measures the rate of the change of delta for each $1 change in the underlying. The closer to being ATM an option is, the higher its gamma, since ATM options are the most sensitive to price-changes in the underlying equity.
Note how the gamma for the 148 and 149-strike calls is higher than the strikes on either side.
Which makes sense, really.
If Stock XYZ is trading at $40, the $40 call will have a higher gamma than the $20 call or the $60 call, since a $1 change in XYZ doesn’t really have a huge effect on the chances of whether or not the $20 call or $60 call ends up in-the-money – they’re both pretty far ITM/OTM.
But a move to $39 or $41 does have a big effect on the likelihood that the $40 call will end up ITM at expiration.
So, getting back to those market makers …
Market makers hedge their options positions by making them delta neutral – that is, they buy shares of the underlying equity to hedge their directional risk.
So for example, if an option has a delta of 0.5, a market maker might purchase 50 shares of the underlying stock to offset the delta of the position. Since there’s a 50% chance (again, roughly) the option will end up in the money, they’ve already got 50% of the shares needed to cover the position if it’s assigned.
But, like we discussed, the delta of an option is constantly changing, which means market makers are constantly buying and selling shares in order to maintain the ‘delta neutrality’ of their positions.
Plus, market makers are constantly opening and closing new positions, which also requires them to adjust their hedges.
So if a market maker sells a huge number of call contracts – say, 1.7 million near-the-money calls – they need to buy up enough shares of the underlying to hedge these new positions.
This creates an increase in demand for the shares, which pushes the stock price higher.
And as the stock price climbs higher, that means more options are now further ITM, ATM, or near-the-money, giving them higher deltas that need to be hedged.
Therefore, market makers must continue buying shares, which continues spiking demand!
Plus, as a stock price begins to climb, you’ll often see traders looking to take advantage of the stock’s momentum by buying call options, further exacerbating the entire cycle!
That is a gamma squeeze, and that is what I thought we were going to see with AAPL options during the first half of the week.
Put A Trade On, Hedge It, & Reverse It
However, a gamma squeeze can also work in reverse.
As a stock price falls, and more call options get further out-of-the-money (and their corresponding deltas drop), market makers have less delta hedging needs.
This means they’ll sell their hedging shares, flooding the market with supply, and further pushing share prices down.
You’ll also see people exiting their call positions, which again, means market makers shed even more delta hedges.
And unfortunately for this week’s call buyers, that seems to be closer to the reality of what happened!
With the market weighing on AAPL share prices into Wednesday, I think the weight of the market was actually suppressing AAPL stock price – perhaps even by $2 to $3.
But as AAPL price fell, the delta of the 150-strike calls fell from about 0.5 down to 0.3 – that’s a ton of delta that no longer needs to be hedged!
Plus, the fact that the heaviest open interest was in positions that expired this past Friday, as expiration approached, even more positions were unwound, further decreasing the amount of shares needed for market makers to hedge.
We can see on AAPL’s chart that Wednesday really pushed the shares lower after a nice rally during the first half of the week.
Even with the market recovery on Friday, AAPL was barely able to finish in the black for the day, and was still well below its early-week highs, and below all of the heavily targeted strikes through expiration.
This is why even if you aren’t trading options, it can be important to pay attention to unusual trading volume in a stock. While unusually large trades can clue you into what ‘smart money’ thinks may happen, paying attention to open interest can clue you into important price levels to watch.
With standard August expiration out of the way, I’ll be watching for any further heavy call action in AAPL’s pits this coming week.
Just because the gamma squeeze didn’t push the tech giant this week doesn’t mean we won’t see more of the same in the weeks to come …
Your Only Option,