My Life My Trade

I recently happen to read Trading Options at Expiration: Strategies and Models for Winning the Endgame by Jeff Auen. I highly recommend this book for anyone who is looking to trade front month options on the Thursday and Friday before expiration. I will share some of the things that I learnt from the book, that I found pretty useful. At options expiration, there are three big market forces at work:

Implied Volatility collapse all day long on Friday: The implied volatility profile of a typical at-the-money option looks like this on the expiration Friday. If one is trading front month at-the-money options on expiration Friday, it is useful to keep in mind that the Implied Volatility (IV) is highest at the start of the day and gets a small bump up near Noon time ET.

Pinning Effect: This comes out of Market Makers desire to leave most of the option holders empty handed (a.k.a. bag-holders). 15 stocks are more likely to get pinned to a strike price more than the remaining others. These stocks are the ones in which options are traded most heavily, namely AAPL, APA, DNA (no longer publicly traded), DVN, FDX, GOOG, GS, IBM, LMT, MA, MON, RIG, RIMM, SHLD, X.

As an example, today GOOG was trading around $415 mark.. There is a good chance that it will end the day tomorrow (Friday) near $410 or near $420. Note that Pinning Effect is different from Max Pain theroy. Max Pain theory is a specific case of Pinning Effect which says that the strike to which the stock gets pinned is the one that maximizes what the Market Makers pocket.

Having this knowledge, I will refrain from making myself believe that GOOG might go beyond $420 tomorrow and buy the *cheap looking* $100 costing GOOG $420 call.. hoping that GOOG makes to at least $425 or so, thereby scoring a 5-bagger. Of course, if for some reason the market makes a big move on the options expiration day (as has happened in Nov 2008 and Feb 2009), a lot of this goes out of the window. However, even if there are crazy moves, as the end of Friday is approached, GOOG will have tendency to end close to a strike price rather than away from it.

Rapidly Accelerating Time Decay: You would have seen this in the theta burn of your options as expiration nears. This is one reason why a lot of people don’t go long options that are expiring in less than two week.

The author talks about specific plays for buying options on Thursday to hold overnight into Friday AS WELL AS Friday only option day-trades, especially some that are to be initiated in the final few hours of Friday. Very interesting read. I am going to be paper trading some of those strategies tomorrow, and will report how it goes, along with some details of the strategies. You can go check more details about the book out here.

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UPDATE Jun 19, 2009: I had some RIMM Jun 65 puts and Jun 90 calls (see this link). RIMM was basically flat after the earnings. So, these options were terribly out of money and were truly worthless. There was nothing in this world that was going to move RIMM down 10 bucks or up 15 bucks today. So, the obvious choice would have been to let them expire worthless. However knowing the IV profile from the graph above, I figured that if at all I had to salvage a dollar or two out of these contracts, I had to do so right at the open. So, right before open, I put in market order to sell these. And guess what, 2 contracts of puts and the 2 contracts of calls that I had – they all sold for $0.05. So, out of the 200 dollars that I had invested in this trade, I got $20 back (LOL – which paid for the book). 5 minutes later, those same options were trading for $0.01.