Open Interest in options contracts can be an important indicator of how the price of a stock is likely to move, especially during the period when options are about to expire.
Why? – Because of the way that options market makers hedge their portfolios.
When a big institutional customer makes a trade in the options market, the counter-party is likely to be options market-makers who issue continuous two-sided price quotes and are willing to take the other side of the trade in return for the bid-ask spread.
The market makers generally don’t particularly want exposure to price movement in the underlying, so they hedge the trade by making an offsetting trade in the underlying stock. For instance, if a market maker sells a call with a .40 delta (meaning that for every dollar that the underlying moves, the call can be expected to change in value by 40 cents - more on options “Greeks” here>>>) they will hedge the trade by buying 40 shares of stock for each call sold.
At least initially, the market maker is not exposed to movements in the price of the underlying. As the share price changes, the hedge will change value – in the opposite direction - by the same amount. That only applies to small movements, however. That call option’s delta doesn’t stay at .40 forever. As the price of the underlying changes, the delta changes as well. This effect is referred to as “gamma.”
For instance, when a market maker is short 1,000 .40 delta calls and long 40,000 shares of stock, the delta of the entire position is zero and the value of the total portfolio doesn’t change much as the price of the underlying shares moves up or down. But if those calls had .1 gamma, when the underlying moves up by $1, the delta of the calls is now .45 and the position (short 1,000 calls and long 40,000 shares) now has a net delta of -5,000. If the market maker wants to remain “delta-neutral,” they have to buy 5,000 more shares of stock.
Now picture that that institutional customer didn’t just buy 1,000 calls, they bought 20,000 calls from 20 different market makers, each of whom wants to adjust the hedge to be delta-neutral when the underlying stock moves. When the shares rally $1, those market makers have to buy 100,000 shares. If the underlying falls $1, they have 100,000 shares to sell.
As expiration approaches, the gamma of options increases, meaning that the market makers will have to buy and/or sell more shares of stock to keep the position hedged. If the market makers are short options, this will tend to exacerbate movement in the underlying as it loves away from the strike(s) that the market makers are short.
If the market makers are long options, their hedge adjustments will tend to hold the share price near the long strike. If the shares rally, market makers will sell as a hedge adjustment and if the shares fall, the market makers will buy – which tends to keep the price near the long strike.
Savvy traders can use this information to make an educated guess about how much a given stock will or won’t move as the expiration of options approaches. If there’s a strike with larger than average open interest, you might notice that the share price tends to move toward that strike. This probably means the market makers are long and their hedge adjustments will tend to limit how much the price moves until those options expire.
If there’s significant market maker short interest on a strike, those re-hedge trades will tend to amplify movement away from the strike in either direction.
Practically, because market maker behavior generally makes their own position deteriorate in value – both in hedge adjustment and in the input of implied volatility into pricing models – when you have the chance, you’ll want to have the opposite position.
If you pay attention to open interest, you can gain clues about whether or not the shares are likely to move heading into the expiration of the options. If you’re considering an options trade, it’s more likely to work out if you have the opposite position from the market making community.
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