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Will The Options Tail Wag The $35 Billion Micron Technology Dog?

July 17,2017 07:23

Micron Technology (NASDAQ:MU) has a $35 billion market capitalization. How can a few options, expiring on a weekly basis, affect such a large market cap? With an open interest of 508,889 call options and 235,174 put options expiring next Friday, July ...


What's the intellectual problem?
Micron Technology (NASDAQ:MU) has a $35 billion market capitalization. How can a few options, expiring on a weekly basis, affect such a large market cap? With an open interest of 508,889 call options and 235,174 put options expiring next Friday, July 21, 2017, we are about to find out. Since each option covers 100 shares, these outstanding options control 74,406,000 shares, or about 7% of Micron's outstanding stock. That's a big number for any company, and is the largest number I can remember in the several years I've been following Micron.
Intellectually, I ought to be equipped to handle the idea that the options tail can wag the underlying stock of a company. I have a business degree, and have heard all about my excellent finance professor's friends Fischer and Myron (that would be Fischer Black & Myron Scholes of the famous and much used Black/Scholes pricing model). I sat on the options desk during my brokerage training. I've read academic papers on the topic. And I've attended numerous classes with options guru John Carter of Simpler Options.
But it just doesn't resonate in my thick head. How can options drive the price of the underlying stock? Sitting through a large options expiration with a portfolio of affected securities and visiting the mailbox for the brokerage statement following such a large expiration brings the message home with a visceral gut punch.
And what exactly is "pinning" and "maximum pain"?
There's a good, if dated, discussion on the topic on none other than Seeking Alpha back in 2011. Prof. Pearson, interviewed in the article, defines pinning as follows:

Pinning refers to the phenomenon that on option expiration Fridays the prices of optionable stocks tend to close on or very near to option strike prices.

And he defines Maximum Pain as follows:

The theory of maximum pain goes further, saying that the stock price will tend to move toward the price where the total value of options contracts, both puts and calls together, is the lowest. This theory thus identifies the specific option strike price that will tend to attract the stock price.

A simple example of pinning for Micron for July 21, 2017, is that the stock may trend towards the nearest strike prices (particularly those with a significant open interest). It closed at $31.79 on July 14, 2017. Let's assume the unlikely scenario that the stock trades sideways between now and next Friday. The "pinning" theory would have the stock "pin" at one of the nearby strike prices: the $31.5 strike price (where there happens to be an open interest of 8,308 call contracts) or the $32 strike (where there happens to be an open interest of 45,908 call option contracts). I guess the $32 contract, covering 4.5 million shares of underlying stock, might have a larger magnetic pull.
What's the Maximum Pain for Micron for July 21, 2017? Spoiler alert: $27 per share.
There are various web sites that calculate Max Pain for different options expirations of different companies. One I like is the aptly named Maximum-Pain.com. You will need to type in the ticker of interest and the expiration date of interest. Here's their picture of the Max Pain for Micron for the July 21, 2017 expiration:

What are the nuts and bolts of why this matters?
As mentioned above, there are options on 74 million shares of Micron stock which expire next Friday. This is roughly $2.1 billion of underlying stock value. The theory goes that the buyers and sellers of options are going to try to move the stock towards the position that will give them maximum profits. But since there are almost 50 strike prices expiring, there's also going to be a lot of pain. Based on last Friday's close of $31.79, if that's the close for next Friday, all the call options with strikes at $32 and above will expire worthless and all the put options with strikes below $31.5 will expire worthless.
Much is made of conspiracy theories, like curiously timed bullish Goldman Sachs research reports and flakey negative Barron's articles. I don't think one needs to go on wild conspiracy witch hunts. Instead, the computers at options market makers are going to attempt to keep their hedging books in line, as this additional quote from Prof. Pearson in the cited article suggests:

Option market makers often have a lot of natural hedging in their portfolios, e.g. satisfying customer demand might lead them to buy some $55 strike calls, and write some $60 strike calls that partially hedge the $55 strike calls. But this natural hedging is not perfect, and to the extent that it is not, options market makers trade in the underlying stocks to hedge their options positions. When the stock price moves, or as time passes, or when they execute new option trades, they need to rebalance their hedges, that is buy or sell the underlying stock.

So what's to be done?
Any news stories that come out this week ought to be examined under a bright microscope. A good example of a "fake news" story was the Inotera stoppage of a week or so ago. Ask yourself whether any new story is biased, particularly this week.
The intellectual Electric Phred would just strap in and sail through whatever storms come up next week. My nearest long options expiry is October, and surely everything will be fine by then? And my stock doesn't expire and should just sail right through, right?
The visceral Electric Phred, still scarred by some past notable Micron options expirations, may sell a profitable position in one account, buy short-term puts in another account, and write barely out of the money short-term call options in another account.
I think the visceral, pummeled side will win out.
And while we are on options, here's a call to David Einhorn of Greenlight Capital, who is back in the stock.
David: Call the fat-fingered traders at Nanya who don't seem to be able to get out of their Micron position fast enough. Write them a put option at $30 expiring in January. Have them grant you a call option at $35 also expiring in January. The aforementioned Black Scholes model tells me no cash should change hands in such a transaction. Nanya should be happy, because they know they have at least $30 to put in their pocket and have potential upside to $35. Greenlight might look very smart, controlling Nanya's remaining ~30 million(?) shares for no money down. Oh, and I guess I'd suggest a European exercise on the put and an American exercise on the call.
Conclusion
I remain very bullish on the supply and demand situation for Micron's DRAM and NAND chips over the short to medium term. But we have the Nanya constant downward pressure on the stock and this little 74 million shares of optioned stock to sail through. I expect this week will be very choppy for Micron stock, but I think that's the sun I see on the horizon.
Disclosure: I am/we are long MU.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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