In a recent article I explored one of the possibilities about who could be the big buyer of Apple (AAPL) stock in Q1 2012, increasing the market cap by almost $200 billion in the process. I suggested option underwriters might be that mystery buyer due to their hedging needs as the option volume was skewed heavily to the call side. I strongly suggest you read that article before this one if you are unfamiliar with option underwriting mechanics.
In the comments section to that article, two legitimate critiques to my argument were raised and I wanted to address those in a follow-up article.
Critique: The underwriters' need to buy stock for hedging purposes is just an indirect effect of demand for Apple call options. It does not mean that option underwriters are pushing Apple's stock up. The real source of demand is the original demand for the Apple call options by the buyers of those options.
While there is a lot of merit to this argument on a logical basis, there are some flaws with it when you consider the actual mechanics of our financial markets.
Investors mistakenly assume what pushes up the prices is an increase in the amount of buyers. The truth is that there can be no such thing as a net buying or selling of a stock in the secondary market. For every buyer there is an equal seller on the opposite side. So sayings like "money is going into AAPL" or "investors are buying up Apple shares" is rather misleading.
There are exceptions to this rule, however. When one of the sides is an outsider to the secondary market, as in the case of a stock repurchase or an insider sale, then there really is some money moving into the stock.
The option underwriters' case falls into this exception case. Underwriters are the creators of the options. They don't sell options that were already trading, but they rather create the options as demand dictates. Therefore, their hedging activities also retain the characteristics of a share repurchase by the company. Basically they release a product into the secondary market (the option they underwrote), and to hedge that they have to take out the equivalent amount of stock away from the secondary market.
A simpler way to analyze it is, when underwriters sell the option to the secondary market they squeeze out cash from that market. Then they turn around and inject that cash back into the stock they wrote the option on. Underwriters basically take away cash from the option investors and they inject it in even greater amounts to the stock itself (because the stock costs more than the option).
The amount they need to inject to the stock to hedge their position exceeds the amount they get out by selling the call option. As a result, in the underwriters' case there is actually money going into the stock. Therefore the option underwriters of Apple become the real source of the money going into Apple stock not the buyers of the call options.
Critique: The delta (sensitivity of the option price to the changes in the underlying) is less than one for most options so the amount of stock required to hedge the short option position is less than the option contract itself. Also a lot of the options are way out of the money and their deltas are even less. Therefore, they can be hedged with quite a little amount of stock position in the underlying.
To start with, the argument that a lot of the options are way out of the money is not correct. The majority of the options volume occurs at the stock's trading level not at out of the money levels.
Also, although the delta hedging argument is correct, it is way more complicated than stated in the critiques. The delta of an option itself is also a moving value. It changes greatly as the underlying price moves away from the strike price. For a true hedged position, you either have to hedge gamma also (which is the sensitivity of delta to the underlying) or you have o incorporate a great deal of margin of error into your delta hedges.
After considering these two complexities, it turns out you still need a substantial amount of stock to hedge a short call option.
I hope these explanations clarify two main issues that were raised in response to my original article. In my opinion there is a lot of merit to the argument that the hedging activities of option underwriters are a big part of the run-up in Apple's stock. Also the huge skew to the call options in Apple, shows that a lot of investors are taking very leveraged positions. This will lead to enormous equity destruction if the Apple stock takes a downturn. This leverage situation is of great importance in my opinion, so I plan to explore it in a separate article. You can follow me on SA to get a remainder when I post that article.
Disclosure: I am short AAPL. I have a short position in AAPL through some short-term put options. I might have closed those positions by the posting of this article.
