Member Frank C. submits the following:

The geniuses in the business press attributed today’s gains to anything from lower interest rates to the Philly Fed manufacturing survey not being quite as bad as expected. But at the same time, jobless claims rose to 378,000–18,000 more than expected. Why lower interest rates were suddenly a sign that happy days are here again, when only the day before the market clearly judged that the Fed’s 75-bps easing wasn’t going to solve the finance industry’s problems overnight, and why a report that begins, “Activity in the [Mid-Atlantic] region’s manufacturing sector showed continued weakness this month,” plus 378,000 pink slips, are signs that the economy isn’t as bad as previously thought…well, let’s just say that we’re dubious.

Maybe we’re due for a real rally after all: News that big investment banks are starting to take advantage of the Fed’s new lending program certainly was a relief to a lot of traders, as was an analyst upgrade of Fannie and Freddie. But another, exceedingly fleeting, factor had something to do with today’s big rally as well: options expiration. During the last trading day before expiration, market makers have to adjust their hedges to cover their short calls and puts. This leads to a phenomenon known as “strike peg”.

Strike peg refers to the tendency for equity prices to move towards the strike prices with the highest open interest at expiration. The idea is that it’s in market makers’ interest for the underlying to trade at a price that minimizes their cost of satisfying their obligations to holders of their short in-the-money options. A market maker can’t move a stock to a desired price on his own, but the activity of all the market makers trading into the final hours before expiration to cover those obligations can be a significant force.

Let’s look at where the open interest was in a few issues today. Index options have the most influence on the market, but they stopped trading Wednesday afternoon–so we’ll look at the index ETFs instead: Open interest in SPY March puts and calls was centered between 132 and 133; in QQQQ, the majority of open interest averaged out between the 43 and 44 strikes. SPY closed the day at 132.08, and QQQQ ended up at 43.09–strike peg.

Since the big investment banks were given a lot of credit for today’s sharp rally, it’s worth examining where the open interest lay in a few of those stocks. For Citigroup, it was clustered in the 22.50 to 27 range; outstanding contracts on Merrill and Amex both peaked at the 45 strike. In each case, the open interest lay well above where these stocks opened the day, and thus created an incentive for market makers to drive their prices up.

Although strike peg has only a temporary influence, at the last minute it can blow up credit spreads you thought were going to expire out of the money. This is yet another reason why we close out our iron condor positions at least a few days before expiration.