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.

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