Expiring With Profit

The following article, written by Bernie Schaeffer and Todd Salamone, is from the winter 2010 issue of Bernie Schaeffer's SENTIMENT magazine, which is designed specifically for those interested in trading options. Every issue of SENTIMENT includes educational pieces for newcomers to options trading, as well as advanced strategy stories to help experienced traders build their portfolios. Please click here if you would like to receive your own copy of the next quarterly issue of SENTIMENT.

The holiday shopping season is behind us, but the hunt for an outstanding deal never ends. Whether it's a plasma TV for your basement, a smart phone, or a cashmere sweater for your significant other, you always strive to get the biggest bang for your buck. The pursuit of "the deal" extends into trading. For option buyers, expiration week comes along once a month and presents an excellent time to shop for attractive option plays.

During expiration week, you can purchase in-the-money options on volatile stocks for little or no time premium—options that can achieve high, double-digit or even triple-digit gains in a week or less. Time decay is the enemy of the option buyer, but in expiration week, option buyers can minimize the dollars they have exposed to this threat. That means, potentially, higher win rates and bigger profits on a given stock move, with only a negligible penalty if the stock stays "flat" (see Figure 1).

In addition, recent changes in option pricing have enhanced the edge for expiration week traders. Although the introduction of penny option pricing and one-point strike increments on many equities may seem like trivial developments, they lower transaction costs and add flexibility, creating opportunities that would not exist otherwise—particularly for those who trade during expiration week.

Pinching Pennies

One-point strike increments enhance the ability of the trader to construct favorable risk/reward scenarios that might not be available with traditional, five-point strike increments. For example, on the Tuesday of November expiration week, GameStop (GME) was trading at support at $24.00. The November 20 call was offered at $4.10, and the November 25 call was offered at $0.30. If you purchased the 25 call, you'd experience a 100% loss if the stock declined, stayed flat, or rallied up to $25. The 20-strike call was more conservative, but with a premium of $4.10, you would need a huge rally to achieve worthwhile gains. However, the 22-strike call—offered at $2.10—was attractive. This option produced a healthy 65% gain when GME climbed to $25.49 by expiration Friday. It also allowed for a comparatively smaller loss in the event that GME stayed flat or moved modestly lower.

"Penny pricing" refers to options priced in penny increments. In the fall of 2009, the Securities and Exchange Commission (SEC) announced that it would expand its penny pricing pilot program to options on 300 additional companies. With penny pricing, it's possible for the bid/ask spread of an option to be only 1 or 2 cents, versus 5 or 10 cents. Reduced bid/ask spreads minimize the ill effects of "slippage" on transaction costs, which is particularly important when trading multiple positions and engaging in multi-legged strategies—the optimal approach during expiration week.

How It's Done

So, now we know that expiration week offers great opportunities for option traders, and recent initiatives in the options industry have given traders a new edge. But how can a typical trader pinpoint prime expiration-week opportunities?

At Schaeffer's, we like to buy calls on stocks that have pulled back to intermediate term or longer-term moving averages and that coincide with levels of heavy front-month put open interest. If the underlying stock respects this double-barreled support, the unwinding of short positions related to the out-of-the-money put open interest could act as a tailwind as the puts approach expiration. The concept is similar for put buying, except that we recommend put trades as the underlying approaches the intersection of heavy out-of-the-money call open interest and longer-term resistance.

The gamma-weighted SOIR is another indicator we rely on heavily during expiration week. The SOIR is Schaeffer's put/call open interest ratio, which divides an equity's near-term put open interest by its comparable call open interest, providing a quick glimpse of investor sentiment. Gamma is one of the option "greeks"—it measures an option's sensitivity to movements in the underlying stock price. Thus, the gamma-weighted SOIR is a refined version of the SOIR that places greater weight on open interest at or near the money. These are the options that have the biggest influence on a stock's behavior during expiration week. For example, an equity with a gamma-weighted SOIR above 1.0 has heavy put open interest near the current stock price relative to call open interest. (You can read all about the gamma-weighted SOIR in "Idea Lab," SENTIMENT Fall 2009.)

Steel-ing Calls

Four days prior to October 2009 expiration, U.S. Steel (X) was trading at $42.52 (see Figure 2), and we recommended the October 39 call for an average entry price of $3.50. X was moving out of a short-term "oversold" condition within the context of an intermediate-term trend higher. The shares were trading just above their 80-day moving average, which acted as support in July, and above the 42 strike, which was home to heavy put open interest. In fact, the front-month gamma-weighted SOIR registered very high at 1.30. We thought there was a fairly high probability that X would pop higher over the four-day period until expiration Friday, driven in part by technical support and the unwinding of short positions related to the soon-to-expire 42-strike put open interest.

The move occurred quickly, as X rallied up to the call-heavy 45 strike the next day. We recommended that our subscribers exit the position at an average of $6.05, ringing the cash register for a 73% gain in just one day. The one-point strike increments allowed us to recommend an in-the-money option that would provide healthy profits if we were correct, while also giving us the opportunity to exit the trade at breakeven if the stock didn't move. Even if X broke through chart and options-related support, the trade could likely have been exited with only a modest loss.

In addition to all these benefits, the shortened holding periods associated with expiration-week option buying allow you to take advantage of mean-reverting market environments such as those we experienced through most of 2009, where big moves were increasingly vulnerable to reversals. The proper mindset for this type of trading is to keep your exposure to the market confined to short intervals and take what the market gives you—that is, potentially sizable gains in short periods, with tight stop-losses when your view is not validated by the market.

Strangling Starbucks

Expiration-week trading also gives you the ability to play multi-directional strategies with defined, minimal risk. Strangle trades—which involve the simultaneous purchase of a put and a call option at nearby strikes—are typically "on sale" during expiration week, because they command lower premiums late in the expiration cycle, and the penalty for buying "double premium" is minimal. With one-point strike increments and penny pricing, you can calibrate the strangle trade with very small risk, profiting on a small move in your anticipated direction or even on an explosive move against your view. The ability to profit from either upside or downside volatility is a major advantage of expiration-week trading. You can't be certain whether the typical bullish bias of expiration week will come into play, or if a big expiration-week decline is lurking, such as the 5% setback in May 2009.

Four days before September 2009 expiration, we uncovered a trading opportunity involving Starbucks (SBUX), a highly shorted stock with big put open interest about to expire. At $20.01, we thought the shares might be poised for a breakout higher. The shares were trading near their highs, and so—remembering that moves to new highs can reverse quickly in this mean-reverting market—we chose a strangle play (see Figure 3).The combined offer price of the September 18 call/September 20 put strangle was $2.36.

Starbucks September 18 call = $2.03
Starbucks September 20 put = $0.33
Total outlay for strangle = $2.36

The strangle trade had a bullish bias, since more dollars were invested in the purchased call option than in the purchased put option, and the call option had a significantly higher delta. Thus, it would take a smaller move by the stock to the upside to achieve profits. The trade would move into profitable territory above $20.36 and higher (18-strike call + $2.36 [total premium] = 20.36). If SBUX shares fell sharply, profits would be realized below $17.64 (20-strike put - $2.36 = $17.64). The minimum value of the strangle position at expiration would be $2.00, equivalent to the difference in the strike prices. So the maximum loss was only $0.36, or 15% (-$0.36/$2.36 * 100 = -15%).

Profit zone for SBUX "strangle"
= below $17.64 or above $20.36
Maximum loss
= -15% (occurs between $18 and $20)

We held the SBUX strangle into Friday's expiration. The shares traded at $20.83 on expiration day, and the call option was sold for an average of $2.81. The shares did not achieve our upside target of $22, but we locked in a 20% gain without losing sleep.

Calling All Bargain Hunters

So, if you're hunting for bargains in the options market, expiration week offers some doorbuster deals that are hard to turn down. Selected in-the-money expiration-week trades provide a once-a-month opportunity for option buyers to dodge the wrath of time decay, maximizing their leverage and profit potential. And, thanks to the SEC's new buyer-friendly initiatives, there's never been a better time to implement these expiration-week strategies.