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Options: Hedging Becomes The Norm

Rules on Wall Street are prone to come with exceptions.

Take the statement that 'expiration weeks are usually positive for the market'. Indeed, 13 of the last 19 monthly expirations have meant good things for the Wall Street bulls, but certainly not this past week. When the Dow closed above 14,000 for the first time on Thursday, it was looking as if the 'positive expiration bias' rule was going to apply again, but the market's rally quickly came to an end on Friday after weaker-than-expected earnings from Google and Caterpillar.

Todd Salamone, senior vice president of Research at Schaeffer's Investment Research says positive expiration weeks are "not a guarantee every time" especially when circumstances arise such as renewed subprime fears and disappointing earnings.

But there's a good reason why most of the last 19 expiration weeks, which span a year-and-a-half, have been positive. Explains Salamone, "our theory is that a buildup of puts related to hedging caps the market as market makers short futures to hedge positions in the puts that have been sold." He says that as expiration nears and puts lose value those same market makers can ease up on their short futures positions "which creates upward bias" in the market going into expiration.

In the week ahead Salamone has this cautionary bit of information:

"Post-expiration week is not as friendly, as only seven of 18 weeks have been positive. We think this is due to the unwinding of bearish put positions during expiration week that supports the market, while the steady build up of index and ETF put open interest that begins the week after expiration pressures the market."

The habit of instiutional and hedge fund investors to hedge risk by building up positions in put options tied to Exchange Traded Funds and market indexes from the S&P 500 to the Powershares QQQ Trust Series, better known as the 'Cubes' has even deeper implications.

Schaeffer's Salamone calls this an "I'm not going to be long unless I hedge market" and says the pre and post expiration options hedging cycle has contributed toward a change in how investors react to market selloffs. He says investors are "less apt to panic if losses in underlying securities are offset by gains in put options positions".

He also says the hedging that keeps more investors from going into panic selling mode and dumping positions may be one reason why the present bull market has yet to see a full fledged 10% correction. The largest market swoon of the year, in early March, featured a market pull back of a little more than 6%.

There is, however, a flip side to the widespread purchase of put options which may be protecting the market, according to Salamone. While market makers offset the puts they've sold to hedgers with the sale of futures contracts, should there come a day when selling in the market goes beyond expectations and market markers find themselves exposed to losses from the puts they've sold, a phenomenon known as "delta hedge selling" could enhance a market decline as market makers are forced to short more index futures contracts.

But Salamone says that type of situation hasn't hit the market since May, 2006.

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