A One-Minute Guide to Expiration

You are totally befuddled by expiration. You don't know anything about it and it bothers you.

I don't blame you one bit. Expiration is hard. I am not even in this primer going to talk about what expiration is, physically. I am instead going to use a baseball analogy and get you to understand what the heck is going on. It is a vast oversimplification, but it might help.

OK, there is a man, the runner, on first. The batter hits a ground ball to the shortstop. The shortstop can throw to first and force out the batter. He can toss to second and the second baseman can step on the bag and force out the runner. Or the second baseman can run over and tag the guy going from first to second.

It is much easier to tag the bag than it is to tag the runner. But sometimes things get messy and you have to try to tag out the runner. But it produces the same result: The runner is out.

Now, imagine that the runner is the underlying stocks in the future that is the S&P 500 and you are short the future because you were negative on the market. I know, I know, a stretch, but I have to try this. Work with me or humor me.

Expiration requires you to get that runner out. You have to do it, you can't be short the future at the end of the day if you want to win. (In other words, accept that the position must be closed out or you will lose the ball game.)

The force-out, the simple way to close out this position, is to buy the future back. The arduous way, the tag of the runner, is to buy back each of the common stocks that makes up the index.

If you missed the force-out for some reason, you have to then go and toss the ball to the second baseman to tag out that runner. It is sloppy and it can go wrong. It can go hideously awry.

This week the second baseman dropped the ball. The runner, the common stock, circled the bases and scored. You didn't get to bring them in because the runner moved too fast. It was a busted play. Baseball can get pretty wild. That's why the S&P flew, not the mumbo jumbo you heard on TV or in the papers about traditional vs. new economy stocks.

I know that purists will grimace at this analogy. But if I walked you through the mechanics I would have lost every one of you. And I will stop at nothing to make you understand this stuff.

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