The Complex Dance Between Short Stock and Short Puts

Mark Wolfinger untangles how professional traders vs. individual investors hedge their risks


What effect, if any, will options expiration this weekend have on the market?

Can we expect some positive pressure tomorrow as options traders close their short stock positions that were covering the puts (now in the money) they sold?

Hello Stoic,

No, but to me it raises an interesting counter-question: Why do you assume that option traders have short stock positions to cover?

If you are referring to individual investors, then for certain the answer is no. These guys and gals do not generally hedge by shorting stock. They just sell their long options when they don’t want to hold them any longer.

If you are asking about market makers, they do not just sell stock and sell puts. They are almost NEVER in a position where they have to buy back short stock. Ask yourself this: Why would a market maker want to buy stock and pay a commission when all he/she has to do is wait to be assigned on the short puts? To be certain there is no risk involved, these MMs already own the corresponding (same strike, expiry) call option to complete the reverse conversion (reversal).

Thus, if somehow the stock surges in price, instead of being assigned on the puts to cover the short stock position, market makers can exercise the calls to achieve the same objective. Those forward conversions are very low-risk positions (only risk is pin risk) and are largely favored by professional traders.

Hope this helps you untangle the likely responses by large and smaller market players the next time expiration and volatility strikes converge like this.