This article originally appeared on The Options Insider Web site.
While everyone looks forward to Fridays, options traders in particular get excited about the third Friday of each month — that is, expiration Fridays — as they provide some unique trading opportunities.
As an options trader, no doubt you’ve been told to close out your expiring positions a few days or weeks before they “come off the board.” And with many plays, that is likely the safest and smartest bet. However, you might be missing out on some of the most exciting action and, more importantly, profits.
Don’t Let Market-Makers Take Your Cash
If you’re planning to enjoy a long weekend away from your computer, it’s probably wise to close out of your expiring options positions in front of that fateful Friday, as you won’t be able to relax when you leave your portfolio up to chance.
But for those months when you’re stationed next to your trading screen, here are some tips for making the most of the last moments you have with your expiring options.
Expiration is 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, you will have yet another advantage over other options traders.
And that advice is as simple as “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.
Keeping Your Cash, Part 1: Call Options
Let’s assume that you own an XYZ Nov 45 Call 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 a $3.90 bid price, and an offer price of $4.10.
Now, let’s digress for a moment and look at this situation through 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, via the $3.90 he paid for the call plus the $45 strike (or, exercise) price of the option.
Since he also sold the stock for $49, he is left with a flat or zero-stock position, and a 10-cent profit per share. Remember that the transaction costs for a market maker are minimal. So that’s almost a $10 profit (10 cents x 100) 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 (upward of 10 million, sometimes even nearing 20 million in a particularly busy session), that could be a very nice day’s work!
OK, back to your situation. If you do nothing with your option, then it 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 the trading day, short the stock at the current market price and then let the call be automatically exercised (i.e., buying shares at the $45 strike price).
You will end up getting out at parity, having a flat stock position and not having any market risk over the weekend.
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Keeping Your Cash, Part 2: Put Options
How does this work for long puts? Almost the same way, except in this case, instead of selling the stock, you would have to buy it. (Remember, calls give you the right to buy stock at the option’s strike price, but puts give you the right to sell shares at the strike price.)
For example, with XYZ trading at $49, the XYZ Nov 60 Put might be bid at $10.70, and offered at $11.30. If you closed out the position by hitting the bid, you would only get $10.70 for your put that is really worth $11.
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 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 a four- or five-contract position makes sense.
Margin and Automatic Exercise
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 in-the-money 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. (Get 5 Tips for Moving Your Brokerage Account.)
Naked Short Options
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.
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.
Even with the automatic exercise rules providing that options that are in the money by even one 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 or her options exercised.
Market Makers and Pin Risk
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 trading 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 for both the company and the shares. Assume XYZ is trading around $51 and there is a large amount of open interest on both the puts and the calls at the $50 strike.
Since the calls are in-the-money, 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 XYZ 50 Puts are in-the-money. 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, thus exerting upside pressure. And so it goes like a seesaw, the stock will teeter around the strike price right through the close of trading.
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 $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 trading very close to the strike. It is this condition that leads to some very profitable trading on expiration day.
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Finding Solid Expiration Day Plays
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 whether 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 trading in a range of about $39.20 to $40.80.
If these conditions are met, this stock might be a potential expiration-day play.
‘Straddling’ The Strike
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 $40 straddle (i.e., a long straddle would mean buying both a $40 call and a $40 put, with a shared strike price and expiration date), which will be trading for a relatively small amount, say 70 cents.
Now let’s think about one of the Greeks; namely delta. (Learn more about “bridging the delta” in 4 Factors in Play When Making Options Trades.)
Since the call is in the money, 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 cents 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 trading platform, you can set it up to work almost automatically.
If you decide to go for it, I’ll be there in spirit with you. Good luck with your expiration-day trading.
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