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Considerations when Managing Risk III. Expiration day

Holding positions into expiration

For traders who frequently adopt the so-called ‘income’ option strategies, the passage of time is friendly and large market moves are the enemy.

Because each passing day bring additional theoretical profits – if the market behaves – it is difficult for some traders to exit before the very last penny has been earned. I have expressed my feelings about the greediness and riskiness of holding to the end (too much risk for too little reward), but there are other considerations worth mentioning.

Please understand that holding options and waiting for them to expire worthless is unrelated to the ideas of actively trading options on expiration day. Jeff Augen’s book [Trading Options at Expiration] offers advice on how to trade expiration day – and that has nothing to do with holding and waiting for options to become worthless.

Holding A.M. settled, European style, options into settlement

Most options expire at the end of trading on a given day – and that is most often the 3rd Friday of the calendar month. There are exceptions:

  • Weeklys
  • Quarterlies
  • VIX options
  • Morning settled European style index options

The one factor to take into consideration when dealing with morning settled European options is the manner in which the ‘final closing price’ or settlement price is determined. It is not a real world price. It is a fictional price calculated on the following:

  • Use the opening price for each stock in the index, regardless of when it opens
  • Assume that each stock is trading at its opening price simultaneously
  • Calculate a value for the index based on the two items above

That methodology may feel reasonably accurate and it may seem as if it represents a real world price. When markets are calm, all assumptions are true. The price is reasonable.

However, there is a lot of risk associated with holding positions (long or short) into that settlement. Consider a bear market, although it works the same way in a bull market. At the opening, thee are many sellers. Some stocks open quickly while others are delayed due to an order imbalance.

Let’s assume that half the stocks open, the published index price is lower, and that those who held positions see the opening stock for the index and walk away, believing they know where the index will settle. Here’s the real problem. Many times, the market has opened at a low,due to selling pressure. The market comes off the bottom and the index begins to rise. However, there are all of those stocks that have not yet opened. There is still the original sell imbalance in those stocks and they eventually open lower, adding more negative impact to the index. However, that impact is not displayed becasue there is now enough support for stocks that opened earlier to keep the published index price from falling.

Bottom line: The settlement price is based on low ticks from 9:30 ET, even though many of those stacks are already trading higher when other stocks open at a relatively low price (the order imbalance often does not disappear until after the opening). None of the published, real-time prices for the daily index comes close to the very bearish final settlement price. When that price is finally published (end of day, or 1PM ET for SET – the settlement price for the SPX index) it may be FAR lower than the published low for the day.

Settlement prices can bring an unwanted surprise. It’s far safer to exit options no later than Thursday afternoon of expiration week.

My bottom line: There is always danger than an OTM option can move ITM. In this blogger’s opinion, it’s foolish to risk a decent chunk of money in an effort to earn that final nickel or dime from a short option position. Others believe that covering these shorts is a complete waste of money. All I can tell you is that in my experience, covering is well worth the cash cost.

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