Apple closes at or near ‘Max Pain’ 8 weeks out of 10


Philip Elmer-DeWitt is a senior editor at Fortune.

New evidence suggests that since last summer the tail has been wagging the dog

If you're any kind of Apple (aapl) investor, you should be aware of the chart at right, even if you don't know a put from a call and don't really care to.

It shows the value in millions of dollars as of Wednesday morning of the outstanding Apple options that expire this Friday, with the magenta bars representing puts (the right to sell 100 shares of AAPL at a certain "strike price") and green representing calls (the right to buy 100 shares).

The theory known as Max Pain says that unless news or other events interfere, the stock will close Friday at or very near the chart's midpoint -- in this case $340 -- the price that causes the maximum pain to whomever has the most money invested in Apple puts or calls. And, conversely, the maximum profit for whomever sold those options.

To what extent this is caused by manipulation or "natural" market forces is a matter of fierce debate (see here, here, here and here). What is clear, thanks to some number-crunching conducted overnight by reader Travis Lewis, is that it's happening.

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In the 46 weeks since July 2, 2010, when the Chicago Board Options Exchange created the Apple "weeklys" -- options that are born, trade fiercely for a week and then expire -- the stock has closed within $1 of Max Pain 38 times, or 83%. If you discount the four weeks in which the stock price was perturbed by a major Apple news event, the percentage rises to 90%.

What this suggests is that an obscure investment vehicle invented by the CBOE to offer investors insurance against wild swings in the market is, to a surprising extent, controlling that market. The tail, in effect, is wagging the dog in a way that has nothing to do with the underlying strength of the company.

Below: A summary of Lewis' chart. The data on which it is based are available on request.



Note: Lewis uses a slightly different method for calculating Max Pain than Jerry Liu, whose free site, optionspain.com,  created the opening chart. Rather than calculate the value of the outstanding options, Lewis tracks the number of open interest contracts.

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