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Does Option Trading Affect Stock Prices?

This question comes up often, and for good reason. One form of logic dictates that greater interest in options must translate to greater buy and sell activity in stocks. This is not necessarily true.

If you are using synthetic positions to take advantage of stock price movement, isn't that the same thing as stock movement? No. Just as shorting stock does not affect whether or not share price declines, trading in options doesn't affect stock prices directly simply because the options are traded. It really doesn't matter how many different option strategies you employ. Trading in options is truly a side play and has no affect on supply and demand for shares, among either buyers or sellers.

One exception to this: There is a tendency for stock prices to gravitate to the closest strike near expiration, known as "pinning to the strike." But even this is only a temporary effect caused by trading with options strikes in mind. Once expired, the options do not affect stock prices any more.

Even the volatility aspect of options is far removed from stock price behavior. Implied volatility (IV) is an estimate of future value and not a reflection (directly at least) of how options affect stock prices. It works in the opposite direction. Historical volatility of stocks, which is calculated specifically, dictates the volatility in options prices and it makes sense to pay attention to this aspect of stock prices in order to better understand option volatility, not so much as an estimate of future changes, but to better understand today's risk and opportunity levels.

Historical volatility reflects market forces, of course. But it also reflects fundamental volatility itself. In this respect, the fundamental trends (including earnings, dividends, and debt management, among other trends) directly affect the technical side and historical volatility. That, in turn, affects option premium and volatility. So the real cause and effect starts with the fundamentals, then to historical volatility, and finally to options volatility.

There is much more to options valuation, of course. This includes the moneyness of each option contract, time remaining to expiration, and even the expectation of earnings surprises.

It's important to recognize what options are and how they work within the market. They can work for speculation only, or as conservative tools for portfolio management. A lot of factors are at play in determining risk and volatility. It is a mistake to assume any single factor is at work. Options valuation is the result of stock price behavior. But affecting the stock price? No.

Michael Thomsett blogs at TheStreet.com, Seeking Alpha, and several other sites. He has been trading options for 35 years. He also teaches on the Candlestick Forum website. To check membership, go to Candlestick Forum membership. His new book can be viewed at tinyurl.com/z44kzlu