Options Expiration: Three Things You Need to Know

Editor's note: This was originally published on RealMoney. It is being republished as a bonus for TheStreet.com readers.

Conventional wisdom has it that options expiration week is a "witching hour" for volatility, as traders rush to put on or roll out positions into subsequent months. While the advent of electronic trading means many traders can roll positions from the expiring front month to subsequent months in a more orderly fashion throughout expiration week, this autumn's environment -- with the VIX at record levels -- presents other challenges for traders pushing their luck in the options market this week. Below is a primer to the hazards of expiration week.

Three Tips for the Volatility Bark That Bites

1. Beware Overnight Shorts in Index Options

Market tenterhooks -- and a 24-hour global news cycle -- mean traders should be mindful of overnight short-covering in index options. Kevin Fischer, head of the block trading desk at Interactive Brokers, cautions that option traders should be vigilant of index options with a.m. settlement -- index options, for which trading stops at 4 p.m. on Thursday night, but for which the cash settlement price is calculated on the following Friday morning, and based on the opening tick of the entire index basket.

For a cautionary tale, consider what happened upon last month's expiration, between the close of trading in the September option contract at 4 p.m. on Sept. 18 and the calculation of the settlement price on the morning of Sept. 19. In the twilight interim between Thursday's close and Friday morning's calculation of the settlement price, the Federal Reserve unveiled a massive, unprecedented, and multi-pronged phase in the bailout of global money markets and the U.S. financial sector.

Following those actions, the cash value of the S&P moved from 1203 to almost 1280 -- a $70 upside move, during which time nobody could hedge positions that had technically expired earlier in the afternoon. Traders who went home Thursday comfortably short of upside calls suddenly found themselves in-the-money and facing exercise.

Fischer said, "The Fed changed the game overnight, and any traders who were short 4% out-of-the-money (1250 strike) upside index calls lost almost $3,000 for every 1 lot when S&P futures opened sky-high on Friday morning. The lesson learned from this is that the current financial crisis has globalized the volatility landscape -- lots of people in lots of different countries are talking about adding cash, changing rules, debating the locate requirement for market-makers, etc.

"What happens during the overnight hours in Asia and Europe can significantly affect our opening. Based on the activity last month, I would expect many traders to close out all their short positions on Thursday. They do not want to go short into Friday anywhere near the closing strike price. In times of extreme volatility, the opening price of a.m.-settled options can be significantly different from the price at the close of trading. And short-players are essentially naked during that period of time."

2. "See Where the Bodies Lie"

Michael K. McCarty, chief options strategist at Meridian Equity Partners in New York City says huge accumulations of put open interest in this contract cycle suggest that despite a blowout rally for stocks at the launch of this expiration week, pressure may lay to the downside as expiration day approaches.

"For a long time, we had an upward bias into contract expiration because the perception was that a generally rising market resulted in a lot of calls landing in the money, thus creating upward bias heading into the closing of expiration. This time around there's a lot of in-the-money puts. If the same holds true, we could see a negative bias going into expiration."

For corroboration of this, McCarty says he's looking "where the bodies lie" -- namely the open-interest accumulations, the strikes at which index cash levels tend to gravitate in connection with expiration.

McCarty explains that in the S&P, open interest has tended toward the round strikes of 950 and 1000, with a significant overweight to the put side (over 100,000 contracts at the October 950 put strike, compared to 24,000 on the call, while at the 1000 strike the proportion stands at 105,000 puts vs. 32,000 calls).

"For the past several weeks, we've noted option trader positioning in October puts in anticipation of meeting liquidations or of liquidating their own funds. It'll be interesting to see how many contracts are actually put this month, as opposed to rolled into subsequent months. In this case, if puts are exercised and liquidated, then you could see some downward pressure into the expiration. The at-the-money straddle in the S&P is pricing in a 68-point move, and with Monday's move amounting to 86 points by closing bell, a move of this magnitude is entirely realistic."

3. Beware Expiration Week's "Volatility Crunch"

Traders of options on single stocks should beware of the "volatility crunch" -- the pinch that occurs when traders are caught long front-month options, which are cheap owing to measly time value, but which nonetheless require a large move in percentage terms in order to prove profitable.

"Right now, especially for those who want to trade in the October contract right before expiration -- there's this concept that people don't want to pay a lot for an option. Rather than looking at the potential percentage move that they need the stock to make in order for the bet to turn profitable for them, they look at price alone. This is especially true on the call side, when the market makes a substantial move, but not sufficient to reach the option's strike price and implied volatility comes off on the call side tremendously. The stock goes up, but the price of the call goes down because implied volatility has come off and there's no time value left to clinch the move," says Brian Overby, senior options analyst at TradeKing in Charlotte, North Carolina.

"Especially with the VIX at these elevated levels, traders should ask themselves how much they need to see a stock move in percentage terms to reach the strike and make the bet profitable," he adds. If the move is more than expected, he favors opting for call spreads (selling a higher strike call in tandem with the long lower strike call) or fewer contracts at a strike closer to the price of the underlying stock.

This was originally published on RealMoney on Oct. 14, 2008. For more information about subscribing to RealMoney, please click here.

Rebecca Engmann Darst is the Portfolio Manager for TheStreet.com's Options Alerts Portfolio newsletter and an equity options analyst for RealMoney. Each Thursday at 6:30 a.m. EST, she delivers the early-morning lowdown on option volume and sector trends on CNBC's "Squawk Box." Prior to her work in the equity options market, she spent seven years in Scandinavia as a Copenhagen-based chief reporter for a European Commission news service, correspondent for Spanish daily El Mundo and Radio Netherlands, followed by stints at Nordea Bank and Saxo Bank.