Today is a monthly expiration in North America. Over the past few years, weekly options began to take away some of the excitement that once surrounded monthly expirations. With the most active options classes expiring once a week, the monthly expirations began to seem like just another Friday.
But now, because individuals and other active traders have been trading options in record numbers, every Friday has a certain level of excitement and monthly expirations are just that much more interesting. (Quarterly expirations, which include index futures, remain the highlight.).
As I write this, the leading tech stocks in the NASDAQ 100 (NDX) are outperforming broader indices like the S&P 500 (SPX) and the small-cap Russell 2000 (RTY). Some of this is because of the worsening Covid news coming from Europe this morning. Those concerns led futures linked to SPX to trade lower in the pre-market, while NDX-linked futures stayed firm. One explanation could be that traders are reverting to the playbook that worked for them – buy the tech stocks that benefit from the stay-at-home trade and sell the more economically sensitive stocks that would be injured if lockdowns return.
Unfortunately, I think that’s only partially correct. I think that explains the weakness in RTY and the underperformance of SPX sectors like banks, retail, and energy. But I think that the outperformance of tech was pre-ordained by options expiration. Today’s rally was as much about high volumes and open interest in upside calls in the largest tech stocks. Stocks have a way of gravitating to strikes with high levels of expiring open interest.
Open interest is the amount of options outstanding on a given strike. It is similar in concept to the number of shares outstanding in a stock, but share counts remain relatively fixed in the absence of corporate actions, while open interest changes constantly. When two traders meet, those are either opening or closing trades. An opening trade creates open interest, while a closing trade shrinks it. Unlike volume, which is updated in real time, open interest is reported at the close of each trading day.
When there is high open interest in a given expiring strike, and that strike is near the current price of the stock, it means that there is the potential for high levels of hedging activity. We have recently seen that volumes in the busiest classes have far outpaced open interest. In the most active TSLA options, for example, we have seen volumes 10x greater than the open interest in many strikes. That means that the vast majority of contracts are “rented” on an intraday basis, rather than owned them overnight. It would imply that professionals are more likely to be long or short the overnight positions, and professionals are more likely to actively hedge than speculators. So if there is a move in the stock toward an expiring strike with high open interest, trading tends to gravitate towards that strike. If the bulk of the open interest is owned by hedgers, they tend to buy low and sell high as the stock crosses the strike. That dampens the movement, and the strike acts like a magnet. If the hedgers are net short, and the underlying stock is in the midst of a directional move, that strike tends to act as a slingshot. Traders who are short options are forced to hedge at inopportune times (buy high, sell low), so their hedging activity can cause a slingshot effect in a fast-moving stock.
As of now, I don’t find it at all coincidental that many of the largest tech stocks are trading around strikes with high expiring open interest. We saw Amazon (AMZN) stock jump right through the 3700 line, with over 5,000 contracts open interest and head almost immediately to the 3750 line with over 4,000 contracts. That is both the slingshot and magnet at work. We saw something similar in Apple (AAPL), where the stock opened just above the 157.5 strike, with an open interest of about 140,000 contracts (combining puts and calls), then moved quickly to the 160 level with nearly 160,000. The Tesla (TSLA) 1100 strike has almost 30,000 open interest, dwarfing the strikes around it. It should not be surprising that TSLA has spent the bulk of the session around that strike today. Do you see a pattern here?
I have always looked to open interest on expiration days to give clues to that day’s trading. For most of my career it tended to inform my views on where stocks might either stall or accelerate. In the current environment, when options trading has seemingly taken on an outsized role among speculators, the clues offered by open interest are even more critical. To be sure, open interest levels are only relevant within the context of the underlying moves in a stock. If there is high open interest below the current strike but the stock is moving upward, that open interest is largely irrelevant. Lately, however, when tech stocks have been moving almost inexorably higher, the inordinately high volumes and open interest in upside strikes have provided critical clues to those stock’s moves.
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