« Daniel Gross: Why Gas Prices Don't Matter to Consumers | Main | Galbraith and the Galbraithians... »

Sunday, May 07, 2006

An Option to Be Manipulated?

This is an interesting puzzle concerning options markets. If you are unfamiliar with options, I have an example at the end that might help.1 For reasons that aren't fully clear, stock prices and their corresponding strike prices are closer together on the days options contracts expire than on other days. One reason for this could be manipulation of stock prices, but there are other explanations and manipulation is not easy to prove:

The Mystery of the Stock Price and the Strike Price, By Mark Hulbert, NY Times: So many options traders lose money that they have grown to suspect they are not operating on a level playing field. A recent academic study provides them with some potentially powerful ammunition. The study, "Stock Price Clustering on Option Expiration Dates," ...[by] Neil D. Pearson and Allen M. Poteshman, ... and Sophie Xiaoyan Ni ... focused on unusual trading patterns of stocks when options on them were expiring. They found an increased likelihood that a stock would close on the options expiration day at or very near the strike price of one of its expiring options.

A strike price, of course, is the price at which an option's owner can buy the underlying stock (if the option is a call) or sell the stock (if the option is a put). A stock typically has options with many different strike prices, set at regular intervals — every $5, for example. Options also vary by month of expiration; all of a given month's options expire on the third Friday.

In effect, the researchers found that the closing prices of stocks that have options were not randomly distributed on expiration days, but instead tended to cluster around the strike prices of certain of their options.

Consider how often a stock closes within 12.5 cents of one of its option's strike prices. On all days other than the expiration date, the researchers found, this happens about 10.5 percent of the time. But on option expiration days, this frequency jumps a full percentage point, to around 11.5 percent. That suggests that option strike prices are acting like magnets, drawing stock prices toward them.

Click to enlarge

This clustering may not seem a big deal, but the researchers say they are confident that it can't be attributed to chance. And the dollars involved are substantial. Some investors' portfolios will increase in value on the expiration day because of the clustering, while others' portfolios will suffer. The researchers estimate that ... these portfolio shifts totaled ,.. [o]n an annual basis, ... more than $100 billion.

Could the cause of this clustering have nothing to do with options expiration? The researchers believe not, since they were unable to find a similar pattern among stocks for which no options exist. They also examined what happened to these stocks when and if options began to be traded on them. They found that clustering generally appeared almost immediately in these stocks' trading patterns on expiration days.

This clustering does not automatically mean that these stocks are being manipulated... It could also be caused by straightforward hedging transactions that are regularly undertaken by market makers on options exchanges. Marty Kearney ... of the Chicago Board Options Exchange said he believes that these market makers' hedges cause the bulk of any price clustering on options expiration day.

The study's authors don't disagree that market makers play a large role. But they found that the market makers' activities could not fully explain the clustering. They say it is likely that manipulation is also taking place.

Who would have an incentive to manipulate stocks this way? One group would be those who sell options short, known as option writers. .... They could lose big if these stocks move too far in the wrong direction.

You would need to be a very wealthy investor indeed to be able to buy or sell enough shares of a stock to move its price... But the researchers believe that some would qualify. They focused ... on ... firm proprietary traders, which includes employees of large investment banks who are trading options... The researchers argue that these traders would be in a position to manipulate stock prices by selling large numbers of shares whose prices they wanted to keep from rising and by buying other shares whose prices they wanted to support.

The researchers say that it is impossible to identify any particular firm that may have engaged in manipulation because they had access only to aggregate data for firm proprietary traders as a whole.

Even if they did have data for individual firms, it would still be hard to prove ... deliberate stock manipulation, which would be illegal. Such proof would depend on demonstrating what the firm's traders were intending to do when buying or selling stocks on expiration day. And there is no shortage of plausible explanations that those traders could provide for their behavior.

In an interview, Lawrence E. Harris, a former chief economist at the Securities and Exchange Commission and ... says the difficulty in proving manipulation is probably an inherent feature of modern markets. "Because the markets are so complex," he said, "it is relatively easy for traders engaged in manipulation to offer alternative explanations ... that would make it difficult to successfully prosecute them."...

At least two major lessons can be drawn from the study, according to Professor Harris. First, he said, "there are limits to what the S.E.C. can do to protect you from the actions of clever traders who arrange their trades to put you at a disadvantage." The second, he said, is this: "Unsophisticated traders should be wary of trading options."
1 An option is as it sounds, you put money down today giving you the option of buying or selling something at a specified price during some future time period. For example, I might pay $10 today to hold a $50 ticket to a concert being held next week. I have no intention of going, I am entirely indifferent about the band, but I believe prices will increase due to high demand and there is a chance to make a big profit. To be clear, when I show up I will still have to pay the full $50 for the ticket, the $10 premium just gives me the option to do so.

When I show-up at the concert, the ticket will be waiting and I pay the $50 for the ticket. If I don't show up, I lose the $10. The $10 is the price of the option and the $50 is the strike or exercise price. If on the day of the concert prices go up to $200, I can exercise the option, get the ticket for $50, and resell the ticket for a $140 overall gain ($200 - $50 - $10).

But what if the price unexpectedly falls to $40? Then I would not want to exercise the option. If I do, I will lose $10 on the resale of the ticket and $10 on the option for a total of $20 (the $10 premium for the option is lost in any case). In fact, for any price less than $50, I would be unwilling to exercise this call option (a call option is the right to buy, a put option is the right to sell at the strike price during the specified period). Stocks and other financial assets work the same way. I purchase the option to buy or sell a stock during some time period in the future at the strike price.

    Posted by on Sunday, May 7, 2006 at 12:15 AM in Economics, Market Failure, Regulation | Permalink  Comments (23)


    Feed You can follow this conversation by subscribing to the comment feed for this post.