Digging Deeper: Clustering and Maximum Pain in the Options Market

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Just a few short years ago, I was a budding academic. I spent as many hours conducting research and attempting to publish in peer-reviewed journals each day as I do covering the markets and lounging around Santa Monica today. While the experience did not make me a professor, it didn't send me to Starbucks (NASDAQ:SBUX) to work as a barista either. Rather, it prompted me to use scholarly work to search for a better understanding in certain areas of interest and my life.

Relative to the areas I studied as an undergraduate and in grad school, there's not much actual (and rigorous) academic research out there on pinning and the subsequent theory of maximum pain. The work that does exist, however, proves sound.

I am in contact with Neil Pearson, Professor of Finance and Harry A. Brandt Distinguished Professor of Financial Markets and Options at the University of Illinois, Urbana-Champaign. Dr. Pearson has authored or co-authored several papers on the issue of pinning (or "clustering" as he and his colleagues called it).

In part one of this series of articles, I briefly review some of Pearson's research. In this introduction, I compare his academic take to popular treatment of the complex workings of the options market. In part two I dig deeper in an interview I conducted via email with Pearson.

Lately, I have written a fair bit about pinning and the theory of maximum pain. I find it fascinating to watch certain stocks to see how they act and react at --or around-- options expiration day. Honestly, it's next to impossible to completely wrap your head around what it all means, let alone track all of the activity with any precision. For this reason, I hope there's a group of academics out there doing the work that the rest of us do not have the resources, or the know-how, to conduct.

For the most part, we're left with mainstream takes on the inner-workings of the options market. While I do my best to provide an accurate, accessible, and concise view of things, I know I sometimes fall short. That said, given the response I have received from Seeking Alpha readers to my articles, I think my works adds value and some level of understanding to a relatively complex subject that will likely never see closure.

Of course, investors and other observers frequently cite Apple (NASDAQ:AAPL) when discussing clustering and its result -- max pain -- in the options market. Claims of manipulation abound. A Seeking Alpha commenter alerted me to a piece penned by Fortune writer Philip Elmer-DeWitt entitled, Is Apple's share price being manipulated?

With all due respect to Elmer-DeWitt, he commits a common rhetorical crime -- setting up an incredibly complex topic as little more than a dichotomy, a mere battle between good and evil. To be fair to Elmer-DeWitt, he may not be responsible for the Bushian logic that populated his article's subtitle; it could have been the work of editors.

There's something very fishy about the weekly options market. Is it time to reel in the bad guys?

Using the very thing that takes an otherwise sound and perfectly reasonable opinion down -- "conventional wisdom" -- Elmer-DeWitt opens his article painting an all-too-perfect picture of call buyers setting themselves up, unknowingly, to get blindsided by some mysterious manipulative force.

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Elmer-DeWitt continues his narrative; it's the stuff of made-for-TV movies.

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He goes on to tidily conclude his Hollywood script by asking the following questions:

How is this manipulation being accomplished? Who is doing it? And why aren't they being punished?

When you read a mainstream author summarize academic research with what sounds like an absolute, be incredibly skeptical. DeWitt wrote, in reference to the Journal of Financial Economics article (co-authored by Pearson) he cited, that

The shares, they [the study authors] concluded, had been manipulated.

Having published and reviewed academic journal articles, I know one thing is certain, absolutes rarely fly.

As an academic researcher, a large part of your work involves considering multiple and alternative outcomes. As I will illustrate, Elmer-DeWitt appears to have misread the research, opting to play the manipulation angle hard, possibly because it aligns with his story. It might even serve to enrage readers. The 2006 New York Times article, however, actually got things right.

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Note the use of the words "likely" and "also" in the last sentence of the Times excerpt versus Elmer-DeWitt's "concluded" and "had been manipulated" in the preceding clip. Also, consider what Dr. Pearson wrote in an email he sent to me Friday morning:

These papers comprise a large body of evidence that delta-hedging has important impacts on the prices of underlying stocks. I think that manipulation also impacts the prices of optionable stocks, but the effect of manipulation is not as important as the effect of delta hedging (emphasis added).

Elmer-DeWitt does not appear to be a writer who lets the facts get in the way of a good story. He gives short shrift to the impact the NASDAQ-100 rebalancing had on the stock. More so, he fails to mention how AAPL trades on a daily basis, regardless of options expiration. You can go check AAPL's price history yourself at Yahoo! Finance for further proof. I include here as much as I can pull from my laptop's smallish screen.

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Finding a day when AAPL does not trade in a wide range of $2.00 to $3.00, at the very least, is akin to finding a needle in a haystack. Fundamental problems exist with the notion that manipulators can nimbly (and consciously) pin a stock to within pennies of a particular price, seemingly at will. This contention paints an all-too-clean and pretty picture. One that would require all of the world's big, bad, and smart money to come together, collectively, and trade from the same room with all of their interests aligned.

In my full-length interview with Pearson, I go more in-depth on the subject of AAPL as well as relatively dense concepts like delta hedging.

I dug into most of the research Pearson sent me (he emailed me five scholarly articles on the clustering as well as related and unrelated topics). While I will devour it all word-by-word in the next couple of days, I summarize some of the aspects of it relevant to this discussion.

In the article referenced by the NYT in 2006 and by Elmert-DeWitt this week, the study's authors (Pearson is the second author) report that their research shows that underlying stock prices do indeed tend to cluster around a particular strike price on options expiration date, so much so that they cannot chalk the phenomenon up to chance. Interestingly, they note:

This difference suggests that the expiration date clustering is produced primarily by cases in which Thursday stock prices that are close to option strike prices remain in the neighborhood of the strike rather than by cases in which Thursday stock prices that are distant from the strike price move to the neighborhood of the strike.

This helps debunk the notion that on a Friday in April, some big trader had the power to manipulate the market (and used it) all of a sudden and take AAPL down over $3.00. Pearson and his colleagues go on to consider four potential reasons for clustering:

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From there, and after a sound analysis, they conclude:

In another paper Pearson sent me from February 2009, the professor and his team discovered that hedge rebalancing by options market makers impacts stock prices generally (i.e., not just at options expiration):

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Again, my interview with Pearson will answer many questions that readers have brought up with relation to AAPL, clustering, and max pain theory in a broader sense-- at least from Pearson's perspective.

I hope this article not only provides a good lead-in to my interview with Pearson, but also drives home a point I have been trying to make lately. As investors, big or small, we have real money on the line. What happens to this cash changes lives and impacts families, for better or worse. It might sound extreme, but it's reality.

I think the way Pearson and his associates decided to end their landmark 2005 study speaks to this sentiment:

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Indeed, if retail traders could use readily-accessible information to not only protect themselves from experiencing max pain, but profit from clustering, chalk one up for Main Street.

When subjects that matter to investors and our investments (or trades) generate mainstream interest, we should not idly accept surface-scratch treatments that misinterpret and leave out crucial facts. I believe in digging for more information and engaging the experts who do a much better job of producing and making sense of that information than I do. This process provides considerable benefit for me. I hope, and humbly believe, that on some level, it does the same for people who choose to spend time reading the results of the work that I do.

*Cited academic sources; most require academic database subscription access

Xiaoyanni, S., Pearson, N., & Poteshman, A. (2005). Stock price clustering on option expiration dates. Journal of Financial Economics, 78(1), 49-87. doi: 10.1016/j.jfineco.2004.08.005

Pearson, N. D., Poteshman, A. M., & White, J. (2009). Does option trading have a pervasive impact on underlying stock prices? Unpublished manuscript, University of Illinois, Urban-Champaign.

>> Continue to Part II

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: Author may initiate a long or short position in AAPL at any time.