Posted by Book Eater

short squeeze theory

I think 17s 18s and 19s of the month are more dangerous


Note: This text
may not be readable for those who do not trade options yet. Just to
clarify for those who may not have basic understanding of options:

Calls- A call option is
a right, not an obligation, to buy shares at a specific strike price.

Puts- A put option is a
right, not an obligation to sell shares at a specific strike price.

There are expiration
dates, deltas (volatility range), open interest volumes (liquidity),
strike price that need to be taken into account, other than the stock
price to calculate the option value. Nevertheless, it's not
altogether rocket science in order to trade these things.

At the money(ATM) calls
for example simply mean – the call option's strike price is the
same as the stock price (or whatever the underlying asset is)

In the money calls mean
that the stock's price is now higher than the call option's strike

Out of the money(OTM)
calls mean that the stock's price is lower than the call option's
strike price.


I always wanted to back
up my theory that we will always be in for a surprise during 17s, 18s
and 19s of the month mainly because options will soon expire those
days. Remember August 17,2007? March 18,2008? and more recently
September 18,2008?

I read an article
written by Adam Warner last August 20,2007 who maintains a blog at
the Daily Options Report and here is the reason why it may be what I
think it to be. He writes:

So how does
putting a market-moving Fed action as close to expiration as humanly
possible have the maximal turbo effect? One word:


Consider a world
where there is just one option, ATM SPY calls. They have a 50
so let's say there is an open interest of 100 where each call gives
you the right to buy 100 SPY's. If they are ATM, the calls have
approximately a 50 delta, so presumably the call shorts own 5000
SPY's, while the longs are short the SPY's.

But the delta
changes as the stock moves. That's the gamma. Let's say the gamma is
10, so in other words if SPY lifts a point, the calls now have a 60
delta. The longs can thus sell 1000 SPY's up a point, while the
shorts have to buy 1000 up a point in order to both stay flat. The
quantities are always going to offset, options are a zero sum game,
so it becomes all about the urgency of the two sides.

And who
has more urgency lately? Clearly the options shorts. So it stands to
reason that the higher gamma gets, the more turbo in the stock.

closer you get to expiration, the higher the gamma. And the more
pressure on the side that is squeezed. In other words with a few days
to go, maybe that gamma is 20. So a one point move causes the
scrambling shorts to buy 2000, while the longs can sell 2000,
probably at prices more their liking.

And what if it turns
back down to the strike? The option shorts now have to sell back
those 2000 shares to flatten out again. And so on and so forth.

then the next day maybe they have 30 gamma near the money. Even more
pressure in each direction exerted by the shorts in this

Which brings us to Friday. Gamma is essentially
infinity in the SPX August options. They have stopped trading. They
are merely cashed out at the "opening" price (defined as
whatever the calculation formula spits out taking the opening tick
from each component). The rate cut and market pop comes an hour and
change ahead of the open. All a call short can do to defend his
position is chase futures/ETF's up. Some OTM calls he is short now
have a 100 delta between now and the open. Sure there is an
offsetting long that can sell the futures/ETF's, but who has the
urgency here? Clearly the squeezed short. And thus the kindling wood
lit by the Bernanke match.

Throw in a similar dymamic on all
other index/ETF options that expire at the end of the day, and Big
Ben literally found the perfect minute to cause the most pain to
options sellers.

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