July 20, 2012 / 8:21 PM / 6 years ago

Unusual price action in four stocks may be due to automated hedge

(Reuters) - A mysterious trading pattern noticed on Thursday in the shares of four blue-chip stocks was likely an experiment in the automated hedging of large options positions, an analyst at JPMorgan said.

Many investors on Thursday were puzzled by the price action of Coca Cola (KO.N), International Business Machines (IBM.N), McDonald’s Corp (MCD.N) and Apple Inc (AAPL.O), said JPMorgan Securities derivatives strategist Marko Kolanovic.

The prices of the four stocks oscillated in an almost perfect pattern, going up and down at almost exactly the half-hour and full-hour marks, he said. The unusual price patterns started from 10 a.m. Eastern time.

“We believe that the price pattern of Coca Cola, IBM, McDonald’s and Apple yesterday was caused by hedging of options by a computer algorithm,” Kolanovic said in a report. “In other words, it was likely an experiment in automatically hedging large option positions with a time-weighted algorithm that has gone wrong for the hedger.”

The unusual trading occurred a day before Friday’s expiration of July options, and the four stocks held some of the largest expiring positions out of all S&P 500 stocks.

It appears that as expiration approached, the automated algorithm was attempting to hedge the large sensitivity of the options to the underlying share price without paying attention to what impact it had on those stocks.

“When traders hedge their long options positions (gamma), they buy and sell stock periodically, often causing it to trade in a narrower range around the option strike price,” Kolanovic said. “If the amount of gamma that needs to be hedged is large, these flows can overwhelm the liquidity and create patterns similar to what we saw yesterday.”

Kolanovic said a computer algorithm was most likely responsible for the trades as no rational trader would trade in such a predictable fashion and time accuracy to his own detriment.

“Moreover, it may be hard to find a reason for buying stocks for 30 minutes and then selling them back in eight apparently meaningless identical cycles,” he said.

Editing by Leslie Adler

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