Was last Friday’s rally a sign of renewed optimism? Or something else? Cash McDash explains the ins and outs of options expiration days (and the games that get played). New deals in the pipeline, the aftermath of the Intrepid Potash deal, and more.

JL: So, here we are after another few days of unpredictable action. Big rallies on strong volume followed by weakness in the face of $120 oil and more bad banking news. How’s it look to you? Think we’re out of the woods yet?

CASH: Yes and no…

JL: There’s a nice definitive answer. Should we shake the Magic 8-ball again?

CASH: Ha ha. Not messing around this week, eh? You’re right, though — it’s tough to have definitive answers in this kind of market. There are so many different time frames and elements to consider. In all fairness, though, I’ve been pretty dang definitive in the trading calls I’ve made these past few months.

JL: True that. You’ve had a pretty hot hand, no doubt. Tell me a little bit more about what you’re seeing overall right now. There seems to be a lot of curveballs flying around.

CASH: Definitely. That big rally on Friday was yet another one. It looks like a strong accumulation day to go along with strong momentum on good volume. But remember what Friday was…

JL: You mean because Friday was the day before Passover weekend? But that would lead to lower volume because of at least a few traders taking the day off, wouldn’t it?

CASH: True, but I’m talking about something else. Friday was also an options expiration day.

JL: Ah, right. Forgot about that. So what does that say about the rally?

CASH: Options expiration days can bring in extra share volume, as traders close out, hedge and re-hedge positions that are affected by contracts expiring. In the last few months, we’ve seen big volatility around expiration days. We’ve also seen traders who are short “out of the money” contracts suddenly caught napping by a sharp move, forcing them to trade out of a tight position. This is the kind of thing where volatility leads to more volatility. The movement can feed on itself and really pump up the market (or knock it down, depending on what’s happening). At the end of the day, I think Friday’s rally was more of a technical move than an actual fundamental shift in the economy.

JL: For our readers who may not trade options or know the mechanics of options, can you give a quick summary of how this works?

CASH: Sure. To start, imagine you were shorting call options on the Dow at a strike price of 12,800. This means you’d be collecting a premium for selling Dow 12,800 calls to the bullish traders who want to buy them. You would receive cash for selling the contracts, and as long as the Dow closes below the strike price at expiration, you get to pocket the cash you sold the contract for.

JL: So the example you just gave is called selling “naked options,” or naked short selling, because the options seller wants the options to expire worthless so he or she can pocket the premium. It’s also extremely dangerous and NOT recommended, because the risk is so open-ended.

CASH: Exactly. Naked options selling may be dangerous, and even foolhardy, but some brave souls do it anyway. It’s different when professionals do it, especially when there are day-to-day strategies for managing the position, but I don’t blame you for sounding an extreme note of caution — especially given the famous trader “blowups” attributed to naked options selling.

JL: Let’s keep going with your example.

CASH: Okay. So let’s say you (or some confident soul) has sold short a bunch of calls on the Dow. You expect the Dow to be flat to down, or at least not to rise above your strike price, so you can keep the premium you collected. But once the index starts trading up and flirting with your strike price, you’ve got a reason to sweat. Here’s where you hedge your risk by purchasing stock.

JL: So a trader is short Dow calls in a neutral-to-bearish bet. He expects the Dow to be flat to down. The Dow starts trading up and threatening to wreck his position and cost him a lot of money. So he starts purchasing stocks — probably shares in the Dow Jones components — in order to offset his risk. If the Dow keeps going up, that means the value of the shares are going up, and so the money he makes on his hedge is meant to offset losses that could be building up on his short options position.

CASH: Yep. And now imagine that a lot of traders were short those Dow calls, or otherwise bearishly inclined after the GE news of the week before. If enough traders were set up in the same manner — which is more likely at a key resistance area — then once the market moves through a certain price point, it can set off a chain reaction of short covering and long-side buying to hedge positions.

JL: So you think Friday’s rally wasn’t quite the “all clear” sign that some might have believed. Instead of signaling fresh optimism, it was a bunch of traders scrambling to hedge their shorts and bailing out of losing positions.

CASH: Exactly. But there’s another side to that coin — and what I’m about to bring up shouldn’t be a surprise to you. After all, we’ve been talking about this week since this time last month.

JL: We have? Refresh my memory. What was last month?

CASH: It’s been almost a month since the Visa deal! And as I’ve said, it takes several weeks to get the road shows underway and bring everybody onboard, but now it’s happening. We’re about to see a big ramp in the IPO markets.

JL: Yes, it’s coming back to me now. And I think you mentioned we have three deals up for this week, too. So you’ve got to be busy with last-minute details right?

CASH: Three? Try five, big boy!

JL: So did you just miss a couple of them last week?

CASH: I’m hurt! Do you really think I was just not paying attention?

JL: I could never think that about you, amigo. That trader’s mind of yours is just too sharp. But where did the other two come from?

CASH: Well, companies and underwriters alike see that the sun is shining for now, and that this could be their only chance to make hay for a while. So now Hatteras Financial Corp (symbol HTS) and Whiting Petroleum Corp (symbol WHX) are on the roster, along with four secondary offerings. Another solar company has placed a stake in the May calendar, too… so we’re starting to see these guys come out of the woodwork.

JL: That’s a lot of new action. The natural question, then, is whether this flurry of deals will dilute the market. How many new issues can this market handle? Will we see less strength than we might have with so many companies competing for the limelight?

CASH: That’s actually a pretty good point. Underwriters do try to spread inventory out over time, as many hedge fund guys (like me) don’t want to be spread too thin. Most traders like to have a few concentrated positions in their favorite names, and are less likely to buy a dozen brand-new companies in the same week. So it’s definitely a balancing act. The underwriters want to take full advantage of a strong market, and yet if they get too greedy and push the deals too fast, many of those deals could flop.

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