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Ready for the Post-Options Expiration Sell Off?

Stocks in this article: SPYEQIXAPOL

After the best September since 1939, stocks have continued their quiet advance right into the middle of October and right into options expiration. Options expiration is the third Saturday of each month, so contracts cease trading the Friday prior to. What does this all mean? In the short term, it means that for those that have been waiting for a pullback to get long this rally, next week, statistically speaking, will be your chance.

A stock market that has been in a steady uptrend tends to rally right into options expiration and then sell off the following week. The reasons are varied as to why. A lot of it has to do with the unwinding of large option-related positions that force the buying of stocks. Another reason is the large number of naked puts sold by hedge funds in order to generate incremental monthly income for their clients. In this case, there is a vested interest in these puts expiring worthless and thus for the light buying of stocks to insure those puts do, indeed, expire worthless. Regardless of the reasons, this pattern tends to manifest itself into the heavy selling of stocks the following week.

Ok, great. A high chance of selling the following week. But how long does the selling typically last and how intense does that selling get? If history is any judge, the odds are for a steady, volatile decline that bottoms on Thursday and then kicks off the next phase of the rally. The S&P 500 is currently hovering between 1170-1180. A normal pullback would take us down to the 1132-1140 area, and the rally could then extend up to the 1250 level.

One way to play this potential move is through November and December call options on the SPDR S&P 500 ETF (SPY). SPY is currently trading between $117.00-$118.00. A pullback on the corresponding S&P 500 levels stated above would put the SPY in the $113.00-$114.00 price range. On a pullback to this level, I would start scaling into the November and December 111 SPY calls. I like to go at least a few strikes in the money (a delta of 70 or greater) in order to get an option that has a high correlation in price movement with the underlying stock. That is, if the underlying stock moves a buck, I want to see my option move by at least $0.70. As an added bonus, the delta on an option increases as the underlying stock goes in your favor. An option that starts out moving $0.70 on each dollar can soon be moving $0.90 on each dollar and even more. An out-of-the-money option with a delta of, say, 20, needs a huge underlying move just to get the option price moving. Although this is great if a huge move is timed perfectly, I would rather buy an option that benefits from the move right from the get go.

Although this same strategy could be done on individual stocks, the safest play during this current heavy earnings reporting period is to just play the index. If a trader chooses to back an individual horse such as Equinix (EQIX) or Apollo Group (APOL) (both of which issued earnings warnings which annihilated their prices the next day), they could be in a situation where they had the right idea but got whacked due to a situation beyond their control. Whereas a single company can get crushed, the overall index might not even bat an eye.

At the time of publication, John Carter held no positions in the stocks or issues mentioned.

OptionsProfits For actionable options trade ideas from a team of experts, visit TheStreet's OptionsProfits now.

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