Is Expiration Friday a Good Day to Shop for Options?

Also, surprise assignment, European-style exercise, playing the VIX and LEAPS on acquired companies.
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Just a day after April's options expiration, the Options Forum takes on a few questions about some possible scenarios on an option bound for extinction. We touch on how last-day plays can work, how a surprise assignment happens and just why almost all index options feature the European-style exercise.

In addition, Bernie Schaeffer's boys explain the predictive power of the VIX and more experts clue us in on what happens to LEAPS when the underlying company gets acquired.

All in all, there's something for everyone this week. Keep the questions coming to

optionsforum@thestreet.com and, hey, give us your full name.

Expiration Bingo

Does it ever pay to buy calls or puts right before the expiration day and, if so, how? -- Fred Kessler

Fred,

Buying calls and puts on expiration Friday is a common practice among professionals on Wall Street, and it is becoming more popular among individual investors with stomachs strong enough to ride Coney Island's

Cyclone

after a three-dog dinner at

Nathan's Famous

.

Essentially, if you can handle the possibility of losing any premium you put up, you can buy expiring calls and puts at their very cheapest. Remember, time is an essential component of options-pricing, so that portion of the option's price gets cheaper as expiration gets closer. But the volatility or intrinsic value of an option can keep prices high sometimes.

What some traders enjoy as a game -- call it expiration bingo -- is buying an at-the-money or out-of-the-money option (it could be a put or a call) and hoping the stock moves enough in the right direction to make them some money.

What might be a little more crafty is selling options to those same gamblers and hoping the stocks don't move in the direction they are betting. That, however, is mucho risky because you could end up needing to deliver, or buy stock on very short notice.

Called Out

I had a covered call on Ziff-Davis (ZD) that expired in March at a 25 strike price. ZD closed at 24 7/8 on expiration Friday, March 19. Monday morning I discovered I was called out and had to deliver my shares. I was surprised when this happened. Is this very common? Ziff-Davis did open up at 25 1/2 that Monday. -- Jeff Davidson

Jeff,

Hmm ... the old get assigned on out-of-the-money calls, eh? Well, call options do give the holder the right to buy the shares of the stock at the strike price, but there's no hard-and-fast rule on what level the underlying stock has to be trading, according to Scott Fullman, chief options strategist at

Swiss American Securities

.

On the surface, it would seem imprudent to pay a higher-than-market price for a stock. "It's not common, but there are a few reasons a call holder would want to do that," Fullman says. For example, it may be that the holder had used the call as a hedge against a short position in the stock, and this is his way of buying the stock, he explains.

Also, it may be a bet on the hope of a one-day rise in the stock price, Fullman says, adding he has seen rare instances where this strategy netted a huge payoff. Once on an expiration day, Fullman says that a company halted trading at midday to announce a big merger. The stock ended up halted for the rest of the day. The stock price at the halt was $5 below some expiring call options, but many option holders exercised the out-of-the-money calls anyway. When the stock opened the following Monday, those who paid up for the stock via exercising the calls were rewarded with a 10-point jump at the open.

"But, again, it's a pretty uncommon practice," Fullman jokes. "Economically, the call seller should be happy. He got a better-than-trading price for his stock."

High-Fat Spreads

Why are most of the index options European-style expiration? In addition, the spreads on index options are crazy! I saw the CMR call 550 12 1/4-13 1/2. Ouch. It just doesn't make sense. It seems to me that European options are in the writer's (seller's) favor because buyers can't sell them until expiration. So, why the huge spread? -- Chris Grange

Chris,

You're right that most index options are European style rather than American style (a notable exception is the

S&P 100

index, which is still an American-style index option).

But you're wrong about the limitations a European expiration carries. You can sell that option anytime you want, you just can't exercise it until the business day preceding expiration. An American-style option can be exercised at any point before expiration.

As to whether a European exercise style favors a seller, well,

yes

, it does. But at a cost, according to the

Pacific Exchange's

Brad Zigler. "Since the risk of early exercise is obviated, there will be less risk premium demanded by the writer or granted by the purchaser. So, it's not a wholly one-sided situation. American-style options would be even

more

expensive."

You didn't specify an expiration for your options, but we'll assume you were looking at the nearby (April expiration) for CMR, the

Morgan Stanley Consumer Index

. As of April 12, the index was at 569.56. The April 550 calls are 19 1/8-21 1/8.

The call's more than 19 points in the money, so the bid looks a little light and the ask looks a little rich. (Theoretically, the option's worth about 19 7/8.) Typically, a market maker or specialist will want to "shade" the bid a little under theoretical value and offer the option a little higher than the model predicts.

But, ask yourself this: With only five days before expiration, what would

you

do as a market maker?

If someone wanted to stick

you

with these options (and from the looks of the open interest in this option class, you would get stuck), how else would you protect yourself? There's no easy way to hedge this option. There are 30 stocks in the index and no futures contract to trade against.

The hedge, if you were selling calls, is buying a basket of 30 stocks. That can get expensive. If you're gonna buy calls? You'll have to sell, maybe sell short, a 30-stock basket!

Now, there may not be a way to justify a 2-point spread, according to Zigler, but sometimes it helps to walk a mile in the other guy's

New Balances

.

Spread rules vary. On the Pacific Exchange, rules dictate the maximum spread for an option with that kind of a premium is 1 point. The CMR, however, is lightly traded at the

American Stock Exchange

and the lack of liquidity adds risk for the market maker and everyone involved.

Does the VIX Predict?

I have noted the Chicago Board Options Exchange volatility index trending lower. It is below a 20-day moving average. Does this serve as an indicator to either be in or out of the market? I notice that, historically, when the VIX is below the 20-day moving average, the S&P 500 is moving up. When the VIX goes above its moving average, the market is trending down. Is that reliable and what does it mean? -- Ron Dunn

Ron,

To get you the best possible explanation, we hit up

Schaeffer's Investment Research

, which bases much of its macro-market strategy on VIX movements.

The VIX, constructed from the implied volatilities of eight near-the-money S&P 100 index, or OEX, options with roughly one month left until expiration, has a strong inverse correlation with the OEX itself, according to Schaeffer's Bob Rack.

He says one reason is that the stock market usually declines faster than it appreciates. Thus, when it declines, actual volatility goes up. Actual historical volatility is one of the primary determinants of future implied volatility, so the VIX will get driven up in these cases.

Conversely, when the market makes gains, actual volatility tends to decrease, so the VIX will decrease as well, Rack says. Another key reason is that the supply and demand for various OEX options is usually balanced. They reach their greatest imbalance during rapid declines.

In those cases, the demand for out-of-the-money puts will greatly increase relative to the supply. As a result, due to various arbitrage techniques, the heightened implied volatilities of those puts will drive up the prices of all other OEX options with it, thus rapidly increasing the VIX while the market declines.

When the VIX does trend, its behavior around the moving averages can be extremely useful for determining market direction. However, the VIX "trends" roughly one-third of the time and "oscillates" the rest of the time.

Since 1990, the OEX has gained at an 11.5% annual pace when the VIX is below its 20-day moving average and at a 23.7% annual pace when the VIX is above its 20-day moving average. This reflects the fact that when the VIX is high, the market tends to rally and the VIX tends to drop (since it oscillates most of the time).

For example, from June 1998 to January 1999, the VIX was in a trending and not an oscillating mode. During that period, the OEX performed much better while the VIX was below its 20-day moving average (64.8% annual). When the VIX was above its 20-day moving average, it didn't perform nearly as well (1.6% annual). This is a huge discrepancy and likely what you noted. Since January 1999, the VIX has mostly been in "oscillating" mode again.

Thus, the real key is to identify the times that the VIX is in a trending mode and then to use moving averages, like the 20-day, to further define your entry and exit points.

Of course, the trick here is to be able to determine when the VIX trends and when it oscillates. As you noted, some of the best gains can be achieved when the VIX is in a downward trend. Complicating matters is that round number levels often play a part. In the past year or so, the VIX, though it is a highly processed number that cannot be directly traded, has been behaving like a stock. In other words, it has been finding "support" and "resistance" at levels that are multiples of five. Draw some horizontal lines at multiples of five on a VIX chart and they act amazingly well as trading channels for the VIX.

Takeover LEAPS

In your column this weekend April 3, you answered a question about what happens to a company's options when the company is acquired. One thing not covered was this situation: What if a person holds LEAPS, let's say, at a strike of 50, expiring in a year, with the underlying stock presently trading at 30. If this company is acquired for $45 cash, is the LEAPS holder left with a worthless contract? -- Kevin Spellman

Kevin,

Sorry, but in this case, the LEAPS are worth one big goose-egg, says Rod Jamieson, options strategist for

Everen Securities

. The LEAPS give the holder the right to buy the stock at 50, and if the merger means that price is not going to happen, the holder ends up with worthless paper. "I mean, technically the options will still trade, but I doubt anybody in their right mind would buy them from you," Jamieson says.

But don't paper your walls too quickly with the useless LEAPS, suggests Jay Baker of the

American Stock Exchange

. Watch what happens with the stock after the deal is announced, he says. If the stock price runs past the 45-per-share offer, that could mean the market is valuing the deal higher or expects another bidder to make a counteroffer, Baker explains.

By waiting, you could be rewarded. "However, if the stock moves up to the offer price, that may mean the market thinks the deal will go through," he notes, adding if the deal closes at 45, then you and your LEAPS are back to square one, or in this case, ground zero.