The monthly options expiration breeds all kinds of concerns about strange volatility and wild moves in the market. It's become a nice all-purpose scapegoat for drastic turns in the market and investors are always wary of the third Friday in any month, when equity and index options expire.
But can something like options expiration be responsible for all that? In reality, it's not so drastic for holders of options in one or two individual stocks but it can knock the broad market around some when the action is writ large across sectors.
We've gotten a bunch of questions from readers wondering how it can affect the overall market, so we sought out some pros to get their take on it. (Remember, if you have any questions about options,
email the forum with your full name and hometown and we'll try our best to help.)
Options expiration causes volatility in the stock market because floor traders, market makers and other professionals, who buy or sell options contracts, often hedge themselves with stock. (Back in the early days of
Chicago Board Options Exchange
floor trader Ross Kaminsky wrote a great piece on
how to play expiration.
It works pretty much like this: Floor traders end up buying calls both from the inventory that's built up in the month's options and from sellers playing expiration days, looking to make some quick premium. In other words, options sellers (you don't have to own an option to sell one) get paid to take the chance that the stock won't move through the strike price on its last day.
If a trader is holding calls that look like they're going to land in the money, he'll dump any shares of stock he holds because he doesn't want to be long in two places. Owning the in-the-money calls is a synthetic long position and owning the stock is a natural one. He doesn't want to take the risk that over the weekend some event will destroy the company while he's holding too much stock.
The reverse is also true: If a floor trader owns puts, he's going to be buying stock -- if the shares look weak -- to hedge himself against some kind of sudden, dramatic run-up on Monday.
If a floor trader ends up selling hundreds of call options to a public customer, the floor trader becomes effectively short the stock because call buyers pay for the right to buy the stock. Now, if those calls get exercised and his options get assigned (meaning he has to fulfill his obligation on the contract), he must have shares on hand to deliver to the buyer.
To make sure he doesn't have to buy stock in a rising market, the trader will buy shares as a hedge when he sells the calls. Let's say they are
September 70 calls. That means that the options will be worthless unless Cisco is at or above 70 by the third Friday in the month.
OK, that's easy enough. The tricky part is what happens on expiration day.
Come Thursday night, Cisco is trading at 68 with no big news expected. That floor trader is thinking that he's going to escape without having to deliver shares of Cisco. Now, remember, he only bought those shares as a hedge, not as a long-term investment. He doesn't like the stock. He doesn't dislike the stock. All that matters is Friday's closing price.
Now Friday morning, he may start to sell Cisco shares or he may wait until the last few minutes of trading. He has a bunch, because he's sold so many options that he may have thousands of shares. He'll start unwinding that hedge on expiration morning, depending on the news. His selling and the selling of other floor traders in the same position can take the stock down.
But (you knew there was a but, didn't you?) there are also floor traders who sold puts. Their hedge was shorting stock, because selling a put -- which gives the holder the right to sell shares at expiration -- obligates the floor trader to buy stock. They're buying stock back to make up for their hedge, which likely a short stock position.
Now, in liquid stocks such as
and Cisco (or on index options where hedges may take the form of individual stocks), that trading can account for millions of shares. Simply put, that's what makes the market shimmy on expiration.
"Expiration volatility is usually good for a couple of ticks in a stock as positions and hedges are unwound," says Alex Jacobson of the
Chicago Board Options Exchange
All of this adjusting of positions creates what traders call "pin risk," the danger of stocks getting pinned, that is, closing at or very close to strike prices (which can be at 2 1/2-, 5-, or 10-point intervals). Individual investors frequently suspect collusion among professionals to keep stock prices in a range where they don't have to fulfill the obligations they've taken on.
The CBOE's Jacobson says, the floor traders are subject to as much "pin risk" as any other investor. Other professionals say any pinning that occurs on expiration day is more a result of natural market activity
Trying to play options expiration is a dangerous exercise for even the most seasoned trader. The volatility is tough to predict and external factors can trump everything else and leave floor traders and individual investors flailing in pursuit of the right move.