A Trader's Guide to Expiration Week

Let's talk about options expiration. Clearly, this brutal week has tossed market bulls into a tailspin. What is it about this time of the month that generates so much fear and confusion?

I'm no expert on hedging practices but I've burned enough capital during expiration to understand its considerable influence on price movement. So as personal therapy, I've compiled a question and answer session on the strange things that happen when the market approaches the third Friday of each month.

Is there a bullish or bearish bias during expiration week?

In reality, there's no bias at all during options expiration week. The market's singular goal is to move equities and indices into prices that force the most options to expire worthless. These levels are referred to as "maximum pain" or magnet prices.

Options expiration tends to act against the prevailing sentiment. So when options week begins with a lot of bullish enthusiasm, there's often an unexpected selloff. When it starts in an overly bearish environment, look for a strong rally to shake things up.

How can traders prepare for expiration week?

Start by reducing your overall exposure, and don't assume that new breakouts or breakdowns will follow through. Figure out early in the week which side of the market has the biggest target on its back. Invariably, that group will feel the most pain during expiration week.

Almost every rally or selloff during this period is a tease because hidden forces are doing their best to shake out both sides of the market. Often, these periods trigger one sharp rally day and an equally sharp selloff day. But most of the time, the net change will hug the flatline by week's end.

Stocks near new highs or lows are most vulnerable to expiration shakeout games. The following scenario is common: A stock breaks out to new highs just prior to expiration and sets up a bullish continuation pattern. But it then sells off with little warning before expiration Friday, leaving anxious bulls with worthless calls.

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Alan Farley is a professional trader and author of The Master Swing Trader. Farley also runs a Web site called HardRightEdge.com, an online resource for trading education, technical analysis and short-term investment strategies. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Farley appreciates your feedback; click here to send him an email. Also, click here to sign up for Farley's premium subscription product The Daily Swing Trade brought to you exclusively by TheStreet.com.

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