Survival Guide To Trading The Stock Market Option Expiration Weeks
By Lawrence
Option expiration weeks offer a lot of trading opportunities that the other weeks do not because the option market makers (can be firms, professionals, or anyone who has enough capital doing it) have to adjust their positions fiercely so that they can come out ahead with a profit by the time the options expire. Many traders who are not aware of this change of participant mix are caught off guard and burnt. This guide is a short explanation to what option expiration weeks are and how to handle the market efficiently during these hectic weeks.
(Note: Long article)
Options Do Not Just Expire On A Specific Date
The common knowledge for most people is that stock market options in North America (and in some other places) expires on the third Friday each month. A general statement like this does no good to anyone who trades during the option expiration week. They would be looking for the wrong clues from the markets they are trading.
In short, the options on stocks, index, index ETFs and index future do not necessary share the same expiration date and time during option expiration week. The difference in their settlement times however is bounded within 24 hours. As all these markets are closely related to each other, the busy settlement schedule forces the market participants to take care of their positions in a haste.
Let’s take a look at the most important instruments on option expiration to see how they expire.
S&P 500 Cash Index Option
SPX cash index options (and other cash index options) expire on the Saturday following the third Friday of the expiration month. However, the last trading day is the Thursday before that third Friday. Hence if you are holding onto your SPY options by that Thursday close, you have to pray that by Friday morning, when the settlement price is calculated, is still in your favour.
Sounds very confusing, isn’t it?
Let me explain it by listing the events in chronological order:
1. By Thursday close, SPX options would stop trading under normal condition
2. By Friday morning, stock market opens, and a settlement price on the cash index SPX is calculated based on the 500 components opening price that morning
3. One full business day to work out which options are expired worthless (the easy part) and which options are settled with cash
4. All options disappear from the traders account after market close on Friday
So you see, the most important moment for SPX options is not how it traded all along during its life time. It is how the cash index open the Friday morning when your bet is already locked in the day before. The overnight changes to the underlying stock prices can change drastically for many reasons. Feels like gambling on a roulette table, isn’t it?
A new version of this option is introduced that behaves like the SPY Options below. The goal for the new version is to resolve this awkward timing problem. After all, if the options are not available there to be traded with the underlying for distribution of risk, it essentially defeats the purpose of having the options available in the first place.
S&P 500 ETF (SPY) Option
Although SPY Options expire similarly to SPX Index Option, SPY Option’s last trading day end right until the end. The settlement price is determined at the same time. Hence the option expiration Friday 4 pm market close on SPY is the single all important price determining the winners and losers for the options expiring that day.
S&P 500 Index Future Option
S&P 500 Index Future Option is the one taking the confusion to the next level.
First the last trade day is the third Friday of the month like the other 2 index based options, but the time is different for quarterly end and the other months. For quarterly ends (March, June, September, December) the last trade time is market open at 9:30 am for the expiring future contracts only. For all other cases including the other months, trading goes all the way to the end of the trading day by 4:15 pm.
Weekly options on the emini index futures are smartly designed to not expire in the same week with the monthly ones to avoid further confusion and complexity issues.
When There Is A Structure You Know Patterns Would Emerge
As I mentioned many times, when there is a predictable structural behaviour, patterns in the price actions would emerge. In this case, since option expiration is putting a deadline on the options, it will affect not only the price of the options themselves but also the related indices and stocks too. The interesting thing though is most people will just stop at the point of understanding the option expiration mechanisms instead of looking for regularities in the price behaviour in the affected instruments.
The behaviour during option expiration week is actually quite predictable overall. It is a surprise description to many people who claimed that option expiration is so complex that it is a losers’ game. What they failed to see is that while majority of retail traders playing the option markets are losing money, the market making firms are consistently making money year after year. If the option expiration is so unpredictable they should not be able to make money overall for so long and so consistently.
The Famous 10-Point Swings On Steroid
When emini S&P making a reasonably strong move, it goes by about 10 points and then pause. It is a well known behaviour.
The interesting thing with option expiration weeks is that as oppose to going in one direction continuously with 10 points move and then followed by pullback with a few points only, emini can easily swing up 10 points and then down 10 points with no warning whatsoever from the price actions. The reason for this to happen is that option market makers are actively adjusting their open positions across many instruments at the same time using buy and sell programs.
Traders who are not aware of this activity are often caught off guard when they thought a direction for the day is defined and trying to hop onto the boat for a continuation ride. What they failed to realize is that after one group of market makers is done adjusting their positions, another group of market makers may have to hedge in the opposition direction. Those who trade in between the strike price levels with stops near the strike price will be stopped out quickly with no good reason.
If you are a scalper who look for pullback setups off the swing trend, during option expiration week, especially the last 2 trading days, will likely be your nemesis. If you do not believe me, check out your trading records for days where you have many trades stopped out. It is likely many of them fall within the option expiration week.
General Option Expiration Price Target
There is no secret that stock market indices like to anchor at strike price by expiration. The problem with the US stock markets however is that the index options like SPX, NDX, OEX, etc. have a different time for the calculation of the settlement price. So there are two fights to nudge the settlement price on the indices. First, the 9:30 am prints for the underlying stocks, which can be affected greatly by the index future markets that trade overnight non-stop. Then, after the morning settlement is done, another fight starts to push the indices towards the targets mainly driven by the index futures and index ETF options.
Notice that for index future options that is about to expire during the quarter ends, they stopped trading in the morning together with the settlement price determined with the volume weighted average price in the first few minutes after 9:30 am. This exposes option spreads / hedges done on different underlying contracts. For example, if you bought a March call on the March contract and written a March call on the June contract, your position would be unhedged after the settlement in the morning of the March quarterly expiration Friday. One trading session may not be that long in duration, but it is long enough to turn many supposedly profitable option positions into losses.
During the option expiration weeks, the indices often swing to one extreme over the range already established in the past three *3) weeks and then swinging all the way to the other end. Option expiration week starting out like that often close near the midpoint of this range.
For option expiration weeks that breakout of the prior established range earlier onward, they tend to double the range of the initiation process (i.e. the first week of the month) as prescribed in STOPD. Due to the non-sequential nature, this property is seldom mentioned anywhere including option textbooks.
Bad Practice Becomes Functional
Due to the 2-way volatile price swings, some traders who usually struggle in other times would score major winnings during the option expiration period.
Who are these traders? They are the ones who average down on losing positions. By averaging into their positions and fearlessly fading the market at potential extremes, these traders would make majority of their profit every month within the option expiration week.
There is this fine line between someone who knows what they are doing and those who don’t on how to average down.
Those who know what they are doing would not be sweating. They would not suffer the emotional swings when their positions look extremely bad going against them because they know from experience and historical behaviour that their average down method will work out most of the time and giving them the expected pay off. When it is not working out, they would take partial losses at the prescribed equity drawdown and continue with the strategy. They would also take partial profits at predetermined price levels to workout the cost of their open positions.
What these traders are doing is essentially a version of the market makers’ strategy in a smaller and more selective scale. The more selective nature makes it possible to average down fewer times so the total capital requirement is greatly reduced.
Now for those who do not understand what they are doing and yet choose to average down, the expectancy does not look good. When they get a lucky break from option expiration volatility, they thought it is their nerve of steel and their brilliant insights are paying off. When they failed badly, they would blame the market is out to get them. Due to this ignorance, and the lack of a plan on how to average down properly, these traders are the primary ones who will be wiped out even though they may have huge equity gains from time to time.
Summary
It is not that complex to trade the option expiration weeks. The most important thing is the awareness of its existence and have a prepared mind in deal with the volatility properly.
If you find the difference in price behaviour during option expiration is not your cup of tea (or coffee), just stay away. You can always choose to do something else as oppose to wasting your time. Remember that if your trading style cannot profit from option expiration weeks for years on a net basis, there is no reason to believe your style will perform in the future either. Not trading during option expiration week is a strategy too because it saves you the frustration, time and commission.
If you choose to play option expiration week, you need to have a specific trading plan in place. For those who prefer to trade with tight stops and not averaging down, you need to switch your game plan to something more flexible during option expiration. For those who want to play the market making game, meaning that you will average down all the time, you have to put in place an exact strategy how it is done with the proper capital requirement fully worked out.
Trading Biases To Lean On During Option Expiration
Option expiration week Tuesday is different from regular Tuesday. Regular Tuesday does not produce noticeable bias throughout the history of Emini S&P. Option expiration Tuesdays, however, has very strong statistical bias that somehow no one mentions it anywhere, including many famous option trading gurus.
Maybe they are keeping the goodies for themselves?
(premium member only content below)
...
Option expiration Friday is unique from other normal Friday. It has a reliable bias to lean on for day trading. I will explain what it is and presenting 2 trading models, one aggressive and one conservative, as demonstration.
(member-only content below)
...
Reference
The specifications for the options mentioned in the article are listed below.
Excellent explanation of one of the most confounding characteristics of the market. Thanks so much, LC.
You are welcome.
Over the years I have explained about the op ex stuff in real-time chat but they are scattered everywhere. It is better to finally put them together in one place as a reference.
Yes, very excellent article. Thanks.
LC, the 2nd paragraph on the section ‘General Option Expiration Price Target’ has a truncated sentence. Redacted trade secret or just distracted writer? 😉
It’s chopped off by the blog software for some reason. With find the original and take care of it. Thanks!
The missing paragraph is added back to the article.