How Option Pros View Expiration

The inside story on expiration day trading

   

How Option Pros View Expiration

Dan Passarelli is an author and the founder of Market Taker Mentoring LLC, the home of personalized, one-on-one options education.
 

Options Expiration: The Inside Story

As a market maker on the Chicago Board Options Exchange (NASDAQ: CBOE), I looked forward to Expiration Friday. It was always the most exciting time of every month. Market makers  – professional traders that worked their own accounts — would spend months, sometimes years, accumulating options inventory in a particular expiration month and trading in and out of positions, which all came to head on Expiration Day. When the bell rang on Expiration Friday to end the day — that was it for those options. They were done. They came off our sheets, as we’d say. That was when we knew for sure whether we made or lost money on the trades.

I don’t trade on the floor anymore. I’m a little older and wiser, and the trading floors aren’t quite the same either. But professional traders still treat expiration as a special day. Options trading investors that use options occasionally can benefit from learning how the professional approaches Expiration Day.

 

How Expiration Trading Is Different

Options expiration is exciting for a number of reasons. For one, it is usually the most active trading day of the month. Trading is much more fun — and usually much more profitable — when it’s busy. Also, trading is usually faster, more final, and there is more risk and more reward, and synthetics come more into play.

Find more option analysis and trading ideas at Trading Strategies.

Speed of Trading

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Option Pit Trading

With a typical option, a trader may have it on for a week, a month, maybe longer. Buying and selling options on the day they are set to expire means it’s a short-term trade — a REALLY short-term trade. By the end of the day, they are guaranteed to be either a locked-in winner or a locked-in loser. There is some excitement in that.

Closing ‘Em Out and Risk/Reward

Because all options are gone — either exercised/assigned, or expire worthless — professional traders spend the day closing out options and maybe rolling them to the next month. Long options decay so fast on Expiration Day that traders are anxious to get out of their negative theta risk. (Theta is a measure of the rate of decline in the value of an option due to the passage of time). If they have any long options, they try and close them all to avoid this risk.

If traders have short options left in their inventory, they represent high (the highest) gamma risk, especially when one considers the potential rewards. (Gamma is the measure of the acceleration of the change in delta). Short options can go from being out-of-the-money winners to being in-the-money losers in a heartbeat on Expiration Day. Remember, short options have limited reward and unlimited risk. If a trader has a short option on expiration day that is worth 10 cents, the most profit he can continue to squeeze out is that final 10 cents. But if the market moves against him, he can lose huge: he can lose dollars. Thus, on Expiration Day traders strive to close out their short option positions too.

Synthetics

Traders, especially market makers, can exploit in a different way the fact that there is usually greater trading on Expiration Day. This can make it easier to trade synthetics – the relationships between options that stem from put-call parity. Put-call parity essentially states that a put can be converted into a position that functions exactly like a call simply by adding stock; and likewise a call can be converted to a position functioning exactly like a put by adding stock.

Put-call parity ensures that prices in the put-call pair at each strike price are kept in line. When a call gets cheap or expensive relative to the price of the put, an arbitrage scenario exists, and that offers up a profit opportunity. Arbitrageurs — like market makers — trade in and out of synthetics, locking in small profits with each trade, on Expiration Day.

 

Expiration – It’s a Wrap

I still look forward to Expiration Day. Sometimes I miss the excitement of the floor but, frankly, I’d rather monitor the markets from home. I may be removed from the trading pits but I understand how market makers treat Expiration Day. And that makes me a better trader.


Article printed from InvestorPlace Media, http://investorplace.com/2011/03/how-option-pros-view-expiration-cboe/.

©2014 InvestorPlace Media, LLC

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