Why Conversions and Reversals Cause Stock Volume Spikes on Expiration Days

to truly understand the cause of volume spikes on Option expiration days, we must comprehend the Put-Call Parity structure that is associated with Conversions and Reversals.

recall an earlier discussion about Put-Call Parity equation. in a gist, a Put is a Call and a Call is a Put. if this sounds confusing, you are on the right track 8-)

[u]Put-Call Parity[/u]
Call = Put + Stock - Strike + Interest - Dividend

and by rearranging this formula,

Long Stock = Long Call - Short Put + Option Strike Price - Interest (carrying cost) + Dividend (of stock)

in otherwords, any Long stock position can be synthetically created by using Options and using some combination of Options, Long or Short stock positions can be synthetically created. now, this is a powerful tool and knowledge.

Market Makers (MM) seize this knowledge to their advantage. In fact, Conversions and Reversals are strategies utilized by market makers every trading day. they have to do so, because they have to accept all orders, both buy and sell. in order to make a profit, they cannot always choose only to buy or sell. almost all market makers will buy and sell throughout the trading session. one of their primary functions is to provide liquidity and get rewarded. however, at times, they find themselves too Long or Short, and risks mount. to defray risks, they "convert" their stock positions into synthetically opposite trades. by doing so, they remove directional bias without having to liquidate existing stock positions yet.

so, if a MM is uncomfortable being too Long XYZ at $100, he/she will immediately Long 100 Put and Short 100 Call to form that Conversion. the MM "converted" his Long stock position into synthetically short stock position, removing his directional risks.

now, come that Friday expiration, the synthetic Short stock (Long Put and Short Call) position could well need to be exercised, if XYZ falls below $100. the market makers does so and automatically, that Long XYZ stock gets sold in the open exchange. even if XYZ price was higher than $100, the fact that those options are expiring, exposing the MM with Long stock directional risks, these Long stock positions will be liquidated. this action contributes to the increase stock volume transactions. MMs are in the business of speculating market directions.

the same can be explained about Reversals, which is

Short Stock + Long Synthetic Stock (ie. Long Call + Short Put)

on Option expiration day, if those Long Calls are exercised, the relevant Stock will be purchased.

retail players do not usually enact Conversions and Reversals. only MMs do so, in order to profit from

a) buying the Bid and selling the offer
b) arbitraging the difference in price of direct stock purchases/selling and synthetic shorts/longs
c) interest rate outlook; conversions are interest rate bearish and reverses are interest rate bullish strategies

these advantages above are very tiny, sometimes less than 5 cents but due to the size of their transactions and very low to near zero commissions on trades, they can make substantial profits if they get them right.

MMs are by far the single largest contributor to stock volume transactions...retailers, commercials and in-house traders trade with them.

so, please don't try Conversions and Reversals unless you are fully aware of the intricacies involved...

and so, now we know the reason for the consistent Stock volume spikes on Option expiration day...because Conversions and Reverses are closed off by MMs.