Lately I've been reading a lot about the supposed manipulation of Apple's stock price leading up to its Q1 2013 earnings call. I've also seen the theory that markets are interpreting Apple's cut of component orders as weak iPhone 5 demand.

The fact that there's so much chatter on otherwise technology-related sites leads me to believe that a lot of Apple customers have become Apple investors. I've written before about why I think this can be a very bad idea. But that aside, I thought I would attempt to debunk the stock manipulation theory a bit and, along the way, do a little Stock Options 101.

Marco Arment recently linked to an article theorizing that large volume call writers might have a strong incentive to manipulate Apple's share price downward.

Before I offer an alternative explanation, let's review what a call option is by example:

  • Johnny thinks AAPL is going to rise above $500 in a month
  • Billy isn't so bullish on AAPL and wants to make a little money right now off of Johnny
  • Billy sells Johnny a call option with a strike price of $500
  • If AAPL is higher than $500 in a month, Johnny gets to purchase AAPL from Billy for only $500; Johnny can then immediately sell AAPL at its actual market value and pocket the difference
  • If AAPL is less than $500 in a month, nothing happens, and Billy keeps the AAPL stock
  • In either event, Billy gets to keep the money Johnny paid for the call option (the premium)

Johnny is willing to risk the cost of the call for the possibility of making a gain in the future, while Billy is willing to risk losing out on future gain for the immediate gratification of receiving the call price.

Now.

Suppose Billy isn't like you and me. Suppose Billy is a ruthless manager of a massive hedge fund. And suppose Billy has written (sold) a lot of call options with a $500 strike. If Billy could figure out a way to make the price of AAPL go below $500, Billy would be assured not only of making a profit (the income from the call options he sold), but he would also be poised to reap any rewards of a price rebound after the call expiration date.

This is the call-option-stock-price-manipulation theory in a nutshell. Is it possible? In theory, yes. Very large investors, by virtue of controlling such a large share of the total market, can manipulate the price of stocks by buying and selling them in huge quantities.

A very entertaining example of such manipulation was carried out by Russell Crowe's character, a London-based bond trader, in the movie A Good Year.

However, such shenanigans are typically only possible over very short periods of time. Markets (or rather, the other big boys) get wise quickly and collapse the gaps. Moreover, such manipulations will probably only move the price slightly, but razor thin movements can translate into million-dollar gains for high volume traders.

Million dollar masochists

If anything is manipulating Apple's share price by way of option trading, simple Econ 101 forces are the most likely culprit. Maximum Pain Theory (MPT), defined by Investopedia, is one possibility:

. . . most traders who buy and hold options contracts until expiration will lose money. According to the theory, this is due to the tendency for the price of a underlying stock to gravitate towards its "maximum pain strike price" - the price where the greatest number of options (in dollar value) will expire worthless.

There are different views as to why MPT occurs, and there are certainly those that don't even believe it's real. But the tendency of stock prices to move toward "high interest" strike prices is too evident in empirical data to ignore.

One explanation for MPT stems from the simple supply and demand forces around call and put options. Puts are, in a sense, the opposite of calls. If an investor buys an AAPL put at a $500 strike, they're purchasing the option to sell AAPL for no less than $500. A put buyer clearly believes the price of a stock will fall below the strike.

Calls, puts, and the underlying stocks on which they are written are inextricably linked in liquid trading markets. Direct investors in stocks use option activity to gauge investor sentiment about the future. Think of them as financial weather forecasts. If calls are in high demand, that means a lot of people think the stock will rise. The opposite is true if put demand is high. And clearly, as the price of a stock moves up and down, so too does the value of call and put options. It's a big ole circle of pain.

Further complicating the path to an option expiration date is the fact that options can be bought and sold themselves. The prices of calls and puts change right up to their expiration dates as more information becomes available and as investors place their respective bets.

If a stock price is well above the strike ("in-the-money" as they say), call holders are likely to sell their positions and cash out. If, on the other hand, the stock price is well below the strike, put holders will take their profits. This selling pressure from both sides will push the stock price itself toward the strike.

Clearly, the closer to the strike the final stock price, the less money put and call holders will make—this is the tendency toward maximum pain. The empirical fact that few people actually make money on long options supports this.

Of course, the sellers don't lose money. As in the example above, they keep the option premium.

The most important part of this post

If the above is confusing, or if you had to read it two or three times and still don't get it, or if you think that MPT is "unfair," you really don't have any business investing in individual stocks. I'm not saying you're stupid. I'm just saying you're better at making money doing things other than playing stocks.

The examples above are as vanilla as it gets on Wall Street. Calls and puts aren't simple concepts, but they are as trivial as learning to count to ten in the world of high finance.

Whether true stock price manipulation is at play or not, there's not much chance you're going to beat the people who do this kind thing for a living. Would you enter a surfing contest where your opponents were not only better at surfing but could also create and calm the very waves on which you're competing?

If you love Apple, buy Apple, not AAPL. Use the technology to get paid for making things yourself.