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Expiration Day Trading
My favorite day of the month is almost here again. While all summer Fridays are good, expiration Fridays provide some unique trading opportunities. Unfortunately for me, I'll be away for a long weekend and since the beach and my computer don't get along, I've closed out all my options that will expire tomorrow. Sell the longs and buy back the shorts. Even though many of them would have expired worthless, it's worth a few bucks to have peace of mind. Since I won't be able to watch the market and I won't be able to trade, closing my positions doesn't leave anything to chance.
Expiration is also the time of the month when market makers make some "bonus" money. This bonus comes from public traders who do not know how to properly exit their positions and leave nickels, dimes or more for the market makers. Since I'm going to tell you how to avoid this little trap, Online Trading Academy students will have yet another advantage over other options traders.
Let's assume that you own an XYZ July 45 Call option and just before expiration that XYZ is trading at $49. The value of your Call should be equal to parity, or $4. In actuality, the market for the Call may be something like, $3.90 bid, offered at $4.10.
Now let's digress for a moment and look at this situation from the eyes of the market maker. If he can buy the Call for $3.90, he will immediately sell (if he has inventory) or short the stock at $49. Then at expiration, the Call will be exercised, so the market maker will end up effectively paying $48.90 for the stock. The $3.90 he paid for the Call plus the $45 exercise price. Since he also sold the stock for $49, he is left with a flat or zero stock position, and a .10 profit. Remember that the transaction costs for a market maker are minimal. So that's almost $10 profit for each option contract, with no risk. Now $10 may not sound like much, but believe me, with the volume of contracts being traded today, that could be a very nice day's work!
Okay, back to your situation. If you do nothing, then the option will be automatically exercised at expiration and when you wake up Monday morning you will have 100 shares of XYZ stock in your account for each option contract you owned. Now you're subject to unwanted market risk; not good. The alternative is to do basically the same thing that the market maker would do. Near the close of trading, short the stock and then let the Call be automatically exercised. You will end up getting out at parity, having a flat stock position, and not having any market risk over the weekend. Sleep well.
How's this work for long Puts? Almost the same way, except in this case, instead of selling the stock, you would have to buy it. For example, with XYZ trading at $49, the XYZ July 60 Put might be $10.70 bid, offered at $11.30. If you closed out the position by hitting the bid, you would only get $10.70 for your Put which is really worth $11.00. So buy the stock at $49 and exercise the Put. If you work through the numbers, you'll see that you're effectively getting the full $11.00 for your Put. You should note that in either the long Put or Call situation, you will have to pay commissions to buy or sell the stock. Even so, with commissions being as low as they are today, saving even 5 cents on 4 or 5 contracts makes sense.
If you're thinking that there may be margin problems in either the Put or Call scenario, you probably can stop worrying. There is something called an "irrevocable exercise notice." This is what allows you to be able to buy or sell the stock without putting up any margin, because you are in effect guaranteeing that you will close the position (via exercise of the option) the same day. Many brokers will see that your ITM option will be exercised and you won't actually have to tell them that you are making this irrevocable election. However, if they ask, that's what you tell them. If they ask, and then don't know what you're talking about (I've heard stories like that) you may want to find a broker who does.
What about naked short options, how do you close them out at expiration without taking a beating? The concept is again similar, except in this case, you don't have control of the situation. Remember, you may be assigned on a short option, but it's not 100% guaranteed. Even with the automatic exercise rules providing that options that are ITM by even 1 penny will be exercised (and that you will therefore be assigned) the holder of a long option position that is only slightly in the money may request not to have his options exercised. The probability of this happening is remote, but because it is possible your broker will probably require margin for a stock trade done in anticipation of assignment. So if your account has the available margin, then you can close out the naked position by buying stock for Calls, and selling (shorting) stock for Puts. If you don't have the margin available, you might have to bite the bullet and buy the options back from the market maker. It will be instructive for you to think through the process.
It's interesting to note, that the actions of the market makers as described above, account for a phenomenon that occurs quite frequently. That's when a stock closing on expiration Friday is very close to a strike price. In fact, some would say that the stock is being dragged to the strike price.
Assume a stock is trading near a strike that has a large open interest in both the Puts and the Calls and it's otherwise a relatively quiet day. Using my favorite stock, assume XYZ is trading around $51 and there is a large amount of open interest on both the July 50 Puts and Calls. Since the Calls are ITM, the market maker will be bidding just below parity. The typical public trader will hit the bid to close out his position. When the market maker buys the Calls he then sells the stock. Since the open interest is large, when enough Calls are bought, there will be a lot of downward pressure on the stock moving it lower and lower. Eventually it will fall under $50 and now the 50 Puts are ITM. So now the market makers will bid just below parity for the Puts. When the market maker buys the Puts, he then has to buy stock, exerting upside pressure. And so it goes like a seesaw, the stock will teeter around the strike price right through the close.
Does this happen all the time; obviously not. There are lots of other forces acting on the stock and in the example above if XYZ was trading at, let's say $67, then regardless of the size of the open interest on the 50 strike, you would not expect the stock to be pushed down to $50. However, when the conditions are right, there is a high probability of the stock being very close to the strike. It is this condition that leads to some very profitable trading on expiration day.
Here's the strategy in general terms. (I give out more specific instructions to my mentoring students, but you can form your own rules as well with a small amount of research.) On the morning of expiration, look for strikes that have the Put and Call open interest within about 10% to 20% of each other, and large relative to other strikes. Of these, determine if the stock is within about 2% of the strike. So if you're looking at a 40 strike, you would want the stock to be in a range of about $39.20 to $40.80. If these 3 conditions are met, this stock might be a potential expiration day trading stock. Let's assume that XYZ is 40.50 and there is huge open interest at the 40 strike. What you do now is buy the July 40 Straddle which will be trading for a relatively small amount, say .70.
Now let's think about one of the Greeks; namely delta. Since the Call is ITM, the position will have positive deltas. So you need to short enough stock to make the position delta neutral. Alternatively, you could have ratioed the Straddle by buying more Puts than Calls so that the initial position is neutral. In practice, I have found that buying the regular Straddle and shorting the stock works best. Now as the stock comes down in price, the Calls will lose deltas and the Puts will gain deltas, making the position short deltas and requiring you to buy stock. So as the stock moves down you will be required to buy and as the stock moves up you will sell. Just what you want, buy low and sell high!
There is an important question and some potential issues with this strategy. The question is, when do you make the adjustments, i.e., how much does the stock need to move before adjusting the deltas? There's no precise answer as far as I know, but the strategy should work out if you use something like 50%-100% of the cost of the Straddle, or 35 to 70 cents in this case. For this strategy to be profitable, you must make enough money on the adjustments to cover the original cost of the Straddle. The problem is that other factors can force the stock to move away from the chosen strike price. If this happens when you first put on the position, the trade may turn out to be a loser. Also, if you decide to do this trade, keep in mind that it either must be constantly monitored or if you have a sophisticated platform, you can set it up to work almost automatically.
Since I won't be trading myself tomorrow, if you decide to go for it, I'll be there in spirit with you. Good luck with your expiration day trading.
As always, if you have any questions about my articles, have suggestions for future topics, or want more information about our options mentoring program, feel free to email me at: sfreifeld@tradingacademy.com or call me at: (888) OTA-2580 ext. 2010.
11. Know Thy Options!
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Stan Freifeld comes to us from the Floor of the American Stock Exchange where he traded options for his own account from 1994-2001. He was a Market Maker for the options on several popular equities including Dupont, Schering Plough, Walgreen's, CBS, U.S. Surgical and Biovail.When he is not trading or thinking about trading, Stan relieves his stress by playing competitive squash, competing in local road rallies with his Ferrari Cabriolet and tutoring local high school students for the SAT's. The bottom line is that Stan, a long time MENSA member, is an engaging teacher with an extraordinary background in options trading and risk management. He is helpful and patient by nature and equally at ease with all levels of traders, from complete novices to advanced pros and academics. He'll be happy to teach you to trade!