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This coming Friday (June 17) is a huge options expiration day. Some $3.2 trillion worth of options contracts expire that afternoon - and it could rock the markets.
Why? Because there's lots of money to be made trading expiration dynamics, and I don't want you to miss this opportunity.
Options expire all the time, some weekly, some monthly, some quarterly, and some yearly. But it's quarterly options expiration (OpEx) cycles that garner the most trading attention, the most volume, have the most open interest, and can impact markets in a big way.
Because there's so much trading in quarterly expiring options, the open interest in them is watched by pros and increasingly by retail traders who are starting to understand what happens behind the scenes.
Open interest is the number of options contracts, calls and puts, that have been entered into (either bought or sold), have not been closed out, and haven't expired. Analyzing open interest in certain contracts going into an expiration can be telling, as far as individual stocks, and more importantly, what the market might do.
For our purposes today I'm not going to focus on individual stocks, though the dynamics are the same. I'm going to key in on index options and trading those.
Let me show you exactly what to do...
Open Interest, Open Book
Some of the best places to look for open interest are in options traded on benchmark indexes like the S&P 500 (SPX), or on ETFs that track market benchmarks, like the SPDR S&P 500 ETF Trust (NYSEArca: SPY) that tracks the SPX, or the Invesco QQQ Trust ETF (NASDAQ: QQQ) that tracks the Nasdaq 100.
By looking at open interest, approaching a quarterly expiration date, it's easy to see how many call and put options contracts are open, how many have to be closed, or might expire either in-the-money or out-of-the-money. In-the-money means for a profit, and out-of-the-money means for a loss.
If you see a lot of open interest in call options, around the at-the-money strike price, and clusters of big open interest in calls above and below that strike, you'd be correct in thinking there's a lot of optimism and betting that the index is going higher since so many traders and investors own calls on the underlying index. The opposite would be true if you saw huge clusters of open interest in put options, investors would be wagering on a selloff in the underlying index.
That brings us to next week's OpEx and the close to $3.2 trillion in open interest in both calls and puts. What's telling this time around is there's actually a lot more interest in call options than put options.
Maybe that's because the market's bounced, maybe because traders think it can bounce more, maybe because it was so oversold, maybe because they think the Fed's not going to be as hawkish as a lot of analysts think they'll be in the months and quarters ahead, or maybe it's something else or a bunch of other things.
What matters is the betting is far more on calls than on puts.
So here's a question you should be asking: who sold all those calls to all those speculators and investors betting the market could keep rallying?
It's not other speculators or investors taking the other side of options buyer bets, whether they're calls or puts - it's market-makers, dealers whose business it is to sell calls and puts.
Most people don't realize it because they don't think about it, but most options contracts don't exist until someone wants to buy one or sell one they don't already own. Then someone else has to take the other side of that trade, so the coming together of a buyer and seller actually creates the call or put contract out of thin air.
For the most part, the "person" taking the other side of newly created contracts is going to be big market-making dealers, like Citadel.
What you need to know is that when dealers sell (in this case, all those calls) options to buyers they're taking the other side of those investors' bets. In this case, they'd be taking on risk if the market goes higher on account of all the call options they've sold.
Dealers will hedge against losing money if the market goes up by buying futures on the market, on SPX, or the Nasdaq, or another index, to make money if the market goes up. They won't ever make as much money on their hedges they'll lose by selling all those calls, but they'll offset a lot of those losses.
Here's Where You Make Money
Going into next week's big OpEx, with dealers at risk of a rising market, they may try and knock the market down.
If dealers are able to knock the market down, by selling futures to push it down, they might panic call option buyers into selling their calls to capture any profit they have, or to cut their losses if they think the market will fall, and they'll lose what they paid for their calls.
The inside skinny is this: as a dealer, if you get the market to fall and the buyers of the calls you sold want to sell them back to you at a loss to them (a gain to you), you'll gladly buy them back. And here's the kicker, the more calls you buy back as a dealer, the less you need those hedges you put on.
Remember, dealers bought futures on indices to hedge their call options exposure, if they sell those futures contracts they're putting more selling pressure on the market. This creates a cascade effect - it could possibly cause the market to fall more, causing more call options buyers to dump their calls, allowing dealers to sell more of the futures they bought as hedges.
In other words, it's a potential wash, rinse, repeat selling cycle that knocks markets back down.
Of course, there's no guarantee that will happen. More buyers could come in, including hedge funds and big investors who bought lots of those calls and want to push the market higher so their call option bets work out big-time.
While it could go either way, this time around I'd be betting the market could come down.
The main reason why is because the market's leaning to the downside already. Just because we had a bounce from oversold conditions doesn't mean it's time to bet on higher markets and buy calls. We're in a bear market as far as I'm concerned.
So, while you could bet the market's going higher and all those call option buyers are right, I'd bet the other way, because the market's bias is already to the downside and dealers may have an easy time trying to sell it down going into next week's OpEx.
If you think the call buyers are right, then buy a slightly out-of-the-money call spread on either SPY or the QQQs that expires in a few weeks.
If you think I'm right and the market will go down next week or after all the options expire and we're left with a "what will the market do now?" mentality, then buy an out-of-the-money put spread a month out on either the SPY or on the QQQs.
Now, next OpEx, you'll know what you're up against and what you can do to maybe make some big money betting on what's going to happen.
It's more important than ever for investors to find ways not only to preserve existing capital but position themselves for the best gains when markets recover. With interest rates rising and inflation staying put, banks are one area where investors are taking refuge.
But we've identified two additional key market sectors where a new flood of buying is going to create opportunities for potentially massive profits, especially in small-cap stocks that often get overlooked by the major players.
I have a strategy to narrow thousands of these stocks down to the few with the biggest potential to be the next market winners.
About the Author
Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.
The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.
Shah founded a second hedge fund in 1999, which he ran until 2003.
Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.
Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.
Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.