With options expiration this week, it is usually a good time to touch on the subject of open interest and understanding what large amounts of put and/or call open interest can mean for certain equities. I have previously written about the possibility of increased volatility during expiration week, and why this dynamic occurs. Now, I’d like to focus on open interest at certain strikes and how overhead calls can cause resistance, and how puts below can provide support.
Calls, which represent the right to purchase 100 shares, are exercised when the option becomes in-the-money (ITM)—i.e. where the stock trades above the strike price. Contrast this to puts, which represent the right to sell 100 shares and are exercised when the stock trades below the strike price—they are then in-the-money (ITM) as well. For the purposes of this blog, I chose two separate stocks, and the first one featured below is the open interest configuration for Metals & Mining firm Vale S.A. (VALE). VALE closed at $18.59 on Monday 3/11, which was below the open interest of the 19-strike calls displayed in the graph. Seeing as these options are out-of-the-money (OTM), it is plausible that this could remain a short-term level of resistance by the end of expiration week.
Why could this act as a level of resistance? Let us say that these calls were bought-to-open, and that the market maker on the floor of the exchange was the other trader selling these contracts. In order to hedge himself in the event of option assignment, he was most likely buying stock for each of the option contracts he was short. Now, as trading resumes throughout the week, and VALE possibly remains below the $19 level, the market maker will no longer need to be hedged as the options remain OTM and he will avoid being assigned. Eventually, he will liquidate his stock that he was holding as a hedge near this level, and thus provide additional overhead supply (resistance).
Puts present a similar concept. Take the open interest configuration for U.S. Steel (X) below, and notice the large amount of put open interest at the 20-strike. X closed at $20.74 on Monday 3/11, and the 20-strike puts remained OTM options. Should X remain above the $20 level, we could see support as the market makers remove their hedges for these options that look to finish OTM by the end of expiration week. The puts that were bought-to-open at this strike were likely hedged by the market makers via short selling of the stock. In order to remove their hedges, the market makers are required to buy back (to cover) the stock that they sell short. This can bring increased buying power (demand) above the $20 level, and act as a “floor” for the stock.
So, in essence, it is important to simply remember this: calls can provide short-term points of resistance, while puts can provide short-term points of support. Try not to over-complicate things, but certainly be aware that large amounts of open interest at particular strikes can have an effect on the underlying equity during expiration week. It is certainly a useful concept to understand.