Tuesday, 16 November 2010
Option expiration is this Friday and it’s not only option traders who need to be extra observant. Even if you’re an average stock investor, there are a couple things you need to know about option expiration week that affect you as well… and your broker isn’t telling you.
Volatility is most likely the first word that comes to mind when you think about option expiration week. Several “experts” on CNBC have begun to stir the “volatility” buzz. Most media outlets tend to exacerbate this misnomer. More accurately, using the word volatile or unstable as the main descriptors for option expiration would not be my choice. Especially not in the last six months.
Of course, in the early days of options trading, option expiration played a larger role because options markets and stock markets for that matter were not as liquid, efficient or easily traded as they are today. Back in the ’70s, ’80s and even ’90s, lower options and stock volume — coupled with fewer market participants — caused weird movements in certain stocks and indexes during expiration… making it a “feared” event.
Being that the mechanics and technology of the markets have changed quite a bit in recent years and options volume has been growing exponentially over the past decade, the behavioral characteristics of options expiration and its volatile past have, in my opinion, greatly dissipated.
In fact, they may now offer you a great opportunity.
What Is Option Expiration?
Every option, by nature, will expire some day. All options that have a “November” expiration date will cease to exist after Friday’s stock market close. This means that option traders have some serious decisions to make this week, whether they are going to buy, sell or hold.
When you think about it though, option expiration is really a wakeup call for traders and investors to assess and adjust their risk… possibly by selling or buying options and/or stock to mitigate their risk.
It creates a sense of urgency for some option traders, in a way forcing them to become a bit more active and bring orders to market, thus increasing volumes and, in turn, adding massive amountsofliquidity. This is especially true for expiration Friday, which is the last day many options can be bought or sold.
(Investing doesn’t have to be complicated. Sign up for Smart Investing Daily and let me and my fellow editor Sara Nunnally simplify the market with our easy-to-understand articles.)
Option Expiration Is NOT Overly Volatile!
What’s interesting is that if you look at the past eight expiration Fridays in the S&P 500, the average high-low variance for Friday was less than 1.5%. That’s not terribly volatile. If you back out the crazy months of April and May, that average drops to about 1.07%.
To put volatility in perspective, let’s use some quick and dirty math. A VIX at 21% basically means that the market expects SPY will move about 1.31% per day about two out of every three days.
Even if we forget the VIX and just focus on the daily average true range (ATR) in the SPY over the past month, it falls right around 1.4%, which is about the same as the past eight months’ average expiration day. In case you’re wondering, ATR is the average greatest movement of a stock over a given period of time.
Why You Should Embrace Option Expiration
So instead of fearing the specter of option expiration volatility, maybe we should embrace the added liquidity of the event and possibly use the other market participants as a means to get more efficient pricing and maybe even more aggressive fills in our stock and options trades due to the fact that most are scrambling to exit as well.
Besides, more buyers and sellers together, generally means more fair and stable prices!
So don’t panic and don’t let the media fool you into thinking expiration Friday is bringing volatility; it’s probably something else.
And Here’s an Option Expiration Tip…
Some stocks, such as Google (GOOG:NASDAQ) in particular, tend to gravitate or “pin” to the option strike that has the most options “open interest” — and that is where it will tend to trade at 4 p.m. Eastern Time on Friday.
Open interest can be thought of as the number of open options contracts held of a particular strike price and month. This information is public, and if you are trading a stock with options, give your broker a call and ask them which November strike price has the most open interest — that might be a price that the stock “sticks” to on expiration Friday.
It’s not a guarantee, but in some stocks you would be amazed at this phenomenon.
Watch the 590 and 600 price points in Google going into Friday. They might be “sticky.”
P.S. When I joined the ranks of the Taipan Publishing Group editors, I quickly learned that my colleague Zach was quite an options guru… albeit a humble one. In the past month alone, Zach has taken option gains of 115%… 42%… 127%… 48%… 38%… and a whopping 210%! Learn more about Zach’s latest options pick here.
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Other Related Topics: Investment Portfolio , Jared Levy , Options Trading , Smart Investing Daily
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