Apple 2.0

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The maximum pain of Apple weekly options: One year later

June 25, 2011: 8:12 AM ET

In 52 weeks, Apple shares closed within $1 of the so-called Max Pain range 39 times

Max Pain. Click to enlarge. Source: Travis Lewis

To ordinary investors, the trading in Apple (AAPL) shares last week must have looked a little crazy. On Monday, when the Dow was up, the stock fell, only to shoot up $9.98 (3.17%) the next day. On Thursday, when the Dow was down, the stock was up $8.62 (2.67%). If Apple could have held on to those gains, it would have registered a rare $15.91 bump from Monday's close. But on Friday, in a pattern that Apple investors find depressingly familiar, the shares fell again and closed at $326.35 -- just about where they ended up the previous week.

To AAPLPain's Travis Lewis, who has been following the trade in Apple weekly options since they began exactly one year ago, it all made perfect sense. Apple almost had to close somewhere between $320 and $330 -- the so-called Max Pain range -- because there was too much money at stake to have it end the week anywhere else.

According to the theory of Max Pain, a stock in which options are traded will tend to close on the day the options expire, absent a major news event, at the point that causes the most pain to people buying options and the maximum profit to those selling them.

It certainly seems to be true for Apple, whose options last week (as they are most weeks) were the most heavily traded of any U.S. stock. In 52 weeks, Apple has closed within $1 of Max Pain 39 times. If you exclude the five weeks in which Apple trading was driven by a major news event -- like an earnings release or a new product introduction -- the Friday close missed Max Pain only eight times in the first year of weekly options trading.

Using Friday's close as an example, here's how it works:

To keep things simple, we'll look only at Friday's two most heavily traded options: the $330 calls and the $325 puts. Each "call" contract gives the holder the right to buy 100 shares of Apple at $330 apiece. Each "put" gives the holder the right to sell 100 shares of Apple at $325.

On Friday...

  • 52,568 calls @ $330 changed hands and
  • 41,751 puts @ $325 changed hands

Since each of those puts and calls represent 100 shares of Apple, the value of the underlying stock at stake is significant. Doing the math:

  • 52,568 x 100 x $330 = $1,734,744,000 worth of Apple
  • 41,751 x 100 x $325 = $1,356,907,500 worth of Apple

Of course, the profit for any option holder is measured by the difference between the so-called strike price ($330 in the case of our calls) and the underlying shares. If Apple had closed Friday where it was Thursday ($331.23), each of those $330 calls would have been worth $123.00. Each $325 call (the second most-heavily traded call option) would have been worth $623.

But the stock fell on Friday, and those 50,000-plus $330 calls and 40,000-plus $325 puts all expired with a value of $0.00. According to Lewis, the total number of contracts that expired worthless on Friday were:

  • Puts: 57,029 contracts representing 5.7 million shares
  • Calls: 31,894 contracts representing 3.2 million shares

Defenders of the options markets disagree, but Lewis, like many in the shrinking pool of retail investors, believes that that weekly trade in options now overshadows trading in the underlying stock. It has become, these critics say, the tail that wags the dog. This can be accomplished in one of two ways -- or both:

  • By outright manipulation, i.e. buying or selling stock to keep its price within the Max Pain range. This is illegal.
  • By "normal" hedging. This occurs when options that are "in the money" are closed. For example, when Apple hit $331.23, some holders of the $330 calls would have sold them to a market maker and taken their $123 profit. That would put the market maker "long" a call. To keep his books in balance, he will usually sell 100 shares, creating downward pressure that tends to┬ádrive the stock back toward Max Pain. (See here for a former market maker's vivid description of other hedging strategies.) All this, as far as the SEC is concerned, is perfectly legal.

"Either way," writes Lewis, "AAPL is being artificially moved. It is not being priced on supply and demand or the valuation of the underlying stock."

Lewis, despite his philosophical objections, has been profiting from the phenomenon by setting up monthly "iron condors" (see here for an explanation of how these work). Another popular options trading strategy is the "iron butterfly" (see here). Both are multi-layered trades designed to take modest profits with limited downside risk in a stock with relatively low volatility.

Lewis has been doing it every month for a year and he hasn't missed yet.

Below: His chart of 52 weeks of Apple Max Pain. For his analysis of what happened last week, see here.

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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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