Expiration Plays Start Early

Some traders think a good Wednesday bodes well for expiration Friday.
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With spring settling in and the crack of the bat still stirring the imagination, there's the chance to view options expiration like the old baseball saw that says the team in first place by the Fourth of July wins the pennant.

There's a school of thought among traders that Wednesday's closing market level may help determine what sort of speculation will be most successful to score on Friday's options expiration with an index play.

David Schultz, of

Summit Capital Holdings

, was one of the believers. "We use it because it works," he said.

An index option is an option whose underlying entity is an index, rather than a stock. Most index options are cash-settled, which means exercise of one doesn't result in the delivery of an underlying asset. This Friday is the regularly scheduled expiration date for every index option except the

S&P 500

contract.

Institutional money managers, and some retail investors, hedge portfolios with index options. Investors can hedge a "long" stock portfolio with options either by buying index puts -- which increase in value as the index falls -- or selling index calls -- bets the index will stay flat or fall.

What Schultz has done is to back-test trading in the OEX, or the Standard & Poor's 100 index options. He pays particular attention to the last hour of trading in flexible OEX options on the Wednesday before each Friday index-option expiration.

"It gives you a very good hint about how the larger market will close on Friday. About six years ago we started noticing this," and this Wednesday seemed to be no exception, Schultz explained. The net advancers-over-decliners indicated the market was moving higher, and Schultz was looking to buy OEX call options, a bet the underlying index would rally.

He got off the phone to buy OEX April 680 calls at 4 3/4 (or $475 per contract). Later in the session, those same calls were trading for 5 3/4 on volume of 4,315 contracts, compared with open interest of 6,745. The OEX index was trading at 681.40.

OEX index option puts were active as well, with April 680 puts trading at 4 7/8 ($487.50) up 1/4 (or $25 per contract) on volume of 11,037 contracts, compared with open interest of 11,309.

If this theory sounds like superstition, the larger truth of Wall Street is that "the market on Fridays is generally up anyhow, just like it's down slightly more often on Mondays," said Greg McMurran, chief investment officer at

Analytic Investors

, a money management firm that specializes in options strategies. "The effect is magnified with options expiration."

Tuesday's

Sovereign

(SVRN)

call buyers were treated to a morning rally that saw the stock pop up as high as 26 1/2 from a close of 17 1/2.

Hopefully, though, the traders who bought the May 17 1/2 calls for 2 1/8 ($212.50) got out early because the stock quickly plummeted and was down 5/8 to just over 16 by midday.

The early rally was

fueled by word that the Mid-Atlantic regional bank was developing an Internet strategy.