Preparing for expiration week
In this crazy options world there is one time in particular that is more chaotic than others. That is expiration week. Expiration week brings with it its own special challenges and obstacles.
There are elements of options trading that are more evident and unmistakable. What we first see in options expiration week is that options move faster than at any other time during an options life. This can be a good or bad thing depending on what side of the trade you reside.
There are reasons for these accelerated and exaggerated movements. The reasons are in the relationships of the option greeks. One of the changes, as we all should be aware from our beginning option classes, is time decay (theta). Time decay increases exponentially during options expiration week. You may have an option two weeks to expiration that may have a theta of $.05 per day, yet in options expiration week that number may be $.25 per day. If you were the owner of that option, you would be losing that 25cents every day. Given that no other factors were involved.
Another thing that changes drastically is the gamma of the options. Remember that gamma is how much the delta of an option changes after the first dollar move of the stock. For example if you had a call option with a delta of 30 (.30) and a gamma of 10 (.10), once the stock moved up $1.00, the new delta after that $1.00 stock movement would be 40 (.40). So now the option would move $.40 with every $1.00 stock movement. Prior to expiration week, you may have an ATM option with only a $.02 gamma, yet during the week of expiration that number may jump up to $.15 or so. This will exaggerate the change in the option price, good or bad, due to stock movement.
On volatile stocks you will see the implied volatility increase drastically. So you can see exaggerated moves in volatility because everything else is moving faster.
So how do you prepare for expiration? The first thing to do is to understand how things work. Some trades should be handled differently than others. I will give you some examples. This is not a complete list, but a general idea of what types of trades benefit from certain option greeks in expiration week and which do not.
Trades that benefit from time decay but with little stock movement. (Positive Theta)
1. Long Calendar spreads
2. Long Butterflies that are ATM (at the money)
3. Long Call spreads that are ITM (in the money)
4. Long Put spreads that are ITM (in the money)
5. Short Iron Condors that the stock is between all the strikes
Trades that are hindered by time decay with little stock movement (Negative Theta)
1. Long Call spreads that are OTM (out of the money)
2. Long Put spreads that are OTM (out of the money)
3. Butterflies that are OTM
4. Long Calls that are ATM or OTM
5. Long Puts that are ATM or OTM
Trades that are hurt by stock movement either up or down (Negative Gamma)
1. Calendar spreads ATM
2. Butterflies ATM
3. Long Condors ATM
4. Short Iron Condors ATM
Trades that are helped by stock movement either up or down (Positive Gamma)
1. Short Calendar spreads ATM
2. Short Butterflies ATM
3. Short Condors ATM
4. Long Condors ATM
With these as well as all types of trades during expiration week, we have to be more aware of how they react to different market forces. If you don’t have the time to keep your eye on trades that are close to a point where you want them in the expiration week, then the best advice is to close that position out.
Here is another thing to consider once you have an understanding of how certain trades react in expiration week. This was a portion of trading that took me a long time to understand. It was patience! New traders have the tendency to not let a trade develop. They exit way too soon, or in their panic, fail to react at all.
Patience and understanding of the markets are skills you develop. The easiest way to start to develop these skills is to understand how options fully work, educate yourself as much as you can, and PRACTICE!!! There is no substitute for a solid options foundation.