On options expiration days, the market tends to move to strikes with high open interest, and to close there. That’s because the options have maximum gamma around the strike and the hedging is furious.

Last night virtually all the in-the-money calls on SPY were exercised, because it went ex-dividend. Note that SPY is the largest index option contract by far. Here’s a table of the open interest at various strikes:

Strike Open Interest

195 118 K

200 205 K

202 180 D

203 148 K

205 192 K

In the last two days we have already seen the 205, 203 and 202 strikes touched and blown through. My guess is that we will also see 200 today. But if we get a late rally, the open interest above the market could make it explosive!

Here’s the reason this works. Suppose you were short a 202 SPY put that expires today. If the market is at 202.01, your put is out of the money and your position at expiration is zero. But if it moves down to 201.99, you are short 100 shares. So to properly hedge yourself (keep delta where you want it) you have to sell some SPY shares. Of course if it moves back up, you have to sell them again. The actors who do this are mostly hedge funds with pure volatility strategies, and they have automatic algorithms to do the trading.

It’s obviously in the interest of the market makers, both human and computer, to encourage as much of this sort of thing as possible. So they probably add a little momentum to exaggerate these moves.

Most of the time this isn’t that important. But today there were about $500 billion of puts (notional value) open in realistic strikes. That’s a big target.