Apple 2.0

Covering the business that Steve Jobs built

How the market in Apple 'weeklys' is rigged

May 15, 2011: 9:32 AM ET

If you're looking for evidence of manipulation, Friday's close was picture-perfect

Volume rose sharply and Apple's share price collapsed in the last half hour

"The easiest way to think of options," wrote The Market Skeptics's Eric deCarbonnel in a prescient 2009 post, "is as a type of insurance. Investors pay a premium to protect themselves against sharp swings in the market. If these sharp swings don't happen, those selling options (option market makers) keep the premiums as profit."

"In a legitimate free market," he continues, "every single option market maker would have already gone bankrupt, especially with the volatility over the last two years. Luckily for option market makers, U.S. markets are neither legitimate nor free."

If he were looking for a case to make his point, deCarbonnel couldn't do much better than the trade that started last summer in Apple "weeklys" -- puts and calls that expire every Friday. As we saw in Thursday's post, Apple's (AAPL) share price tends to gravitate with uncanny accuracy toward the closing price that causes "max pain" to option buyers and maximum profit to option sellers -- often in a burst of last-minute trading.

In that respect, Friday's close was picture-perfect.

On Friday morning, when Apple opened at $345.79, there were about 70,000 weekly option contracts set to expire that afternoon, roughly split between puts and calls (see definition at right). The most important were the $350 calls, with about 11,000 contracts outstanding, and the $340 and $345 puts, with about 16,000 contracts between them. The best scenario, from the contract writers' point of view, would be for Apple to close above $340 and below $350.

At 3:14 p.m, Apple was trading at $343. The $350 and $345 calls were safely out of the money, but there were still a few thousand open $340 call contracts worth $300 each.

So what happened? At 3:16, in a pattern that has become as predicable as rush hour traffic, sell orders started coming in, first as a dribble, then, at 3:22, as a flood. In the space of less than five minutes, 500,000 shares changed hands and the stock dropped nearly $3. When the closing bell rang, Apple stood at $340.50. The value of the $340 calls had shrunk from $300 to $50.

Meanwhile, tens of thousands of calls with higher strike prices -- the $345s that were heavily traded on Thursday, the $350s that were most widely held, the $355s, $360s, etc. -- all expired worthless. The options writers pocketed the premiums as profit, just as deCarbonnel said they would.

Thursday's weekly calls. Source: Travis Lewis

If you're like me and are having trouble following the plot, you might find the first video posted below useful. It was put together by reader Travis Lewis, who dabbles in monthly options and has been watching this narrative repeat itself nearly every Friday since trading in Apple weeklys began last summer. In the video he shows how, using a snapshot of Thursday's outstanding puts and calls, he can predict to within a few dollars where the stock is going close the next day -- barring big news that even the option writers can't control.

Speaking of news, rumors and press reports can play a role in this game, either by helping drive the share price or -- depending on how cynical your point of view -- providing a fig leaf for the traders who are controlling the action behind the scenes.

As it happens, The Street.com's Scott Moritz posted a report at 3:52 Friday afternoon that hit four of Apple's hottest sell buttons: The iPhone 5 delay, the stock's depressingly sideways trading pattern, the rise of Google's (GOOG) Android and concerns about Steve Jobs' health.

Cramer vs. Stewart. Source: The Daily Show

Because The Street comes up a lot in stories about Apple manipulation (see for example here and here), I've posted two more videos below. They're from The Street's famous interview with Mad Money's Jim Cramer, in which Cramer talks about how Apple's share price can be manipulated by fomenting bogus iPhone rumors. The clips, which The Street pulls off YouTube whenever they pop up -- come courtesy of Jon Stewart's Daily Show. I don't know how many times I've watched Cramer get sliced up in these clips, but every time I do I find Stewart's outrage cathartic.

It's worth noting that buying or selling securities for the purpose of  "pegging, fixing or stabilizing" the price of those securities is illegal. Defenders of weekly derivatives will tell you that natural market mechanisms are what cause options to close at max pain. But every academic paper on the subject I've seen -- including Jerry Wenjiu Liu's 2009 study of Google options -- reject that hypothesis. Retail investors might close out a few thousand in-the-money calls just before expiration to avoid taking possession of the stock, but they don't control enough shares to turn a ship as big as Apple around.

This is the second in a series of posts about the alleged manipulation of Apple's share price. You can read the first one here. In our next piece, we'll see if we can figure out who is pulling the strings.

UPDATE: The Street has responded with a long post by an options trader named Mark Sebastian who describes, better than I ever could, what probably went down last Friday. Although he misquotes me high up and does not speak kindly about my work, the story he tells is fascinating. It's a real inside-the-boiler-room tale, so filled with delta scalpers and iron butterflies it's almost impossible to parse, but it gives you a good feel for what life for high-stakes options traders must be like.

Let's go to those videos:

Travis Lewis' walk-through Thursday's options:

Cramer on the Daily Show, via Roughly Drafted Magazine:

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About This Author
Philip Elmer-Dewitt
Philip Elmer-DeWitt
Editor, Apple 2.0, Fortune

Philip Elmer-DeWitt has been following Apple since 1982, first for Time Magazine, and now on the Web for Fortune.com.

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