This information comes from “Perdant of Topstocks.” I hoope you find it of interest.

The first part is a recent article [11/6/07] from The second part is from some articles from ‘96 in what was then known as the Option Fool [now Motley Fool] that i thought might be of interest. There are three: Pre expiration effect, option expiry day itself; and the Post expiration effect.

Sorry it’s long.Perdy

Of interest: Over the last two years, the Wednesdays and Thursdays of the week prior to options expiration have had “true ranges” (a measure of volatility) that were 9% above average.

Over the same period, the Friday of options expiration week has closed higher than the prior Friday 75% of the time. Non-expiration Fridays have closed higher than the prior Friday 55% of the time. So over the past two years, expiration week has had a distinctly positive bias; this following the 9% higher-than-average volatility of the Wednesdays and Thursdays of the week prior to expiration.

The pattern seems to be some selling late in the week before expiry, with a bounce during the week of expiry. So far, the pattern is playing out “according to Hoyle.” If the market can’t work its way generally higher this week, then we’ll have another piece in the puzzle of a changing market character.

The market seems to sell off late in the week before expiry and bounce during expiry week.
So far, that pattern seems on track.If it doesn’t play out, we’ll know the market’s character has changed.

Triple witching refers to the market machinations brought on by the simultaneous expiration of stock index futures, stock index options, and stock options. This happens four times a year, on the third Fridays of March, June, September, and December.

To be precise, the phrase is Triple Witching Hour, and refers to the last hour of trading on these Fridays. The expiration of these vehicles can cause high volatility in stock prices as traders play madly with the expiring vehicles and the underlying securities.

Topic: The Pre-Expiration Effect

Have you taken a look at OEX equidistant option premiums during expiration week (esp. Tuesday and Wednesday) for a clue as to what the “expiration bias” might be?

I was wondering if during expiration weeks the “smart money” (market makers) can overpower the “normal” put/call relationship based on informed information about expiration buy side/sell side direction.

Barron’s ran something just after the November expiry about how “overpriced OEX calls” correctly predicted an upside bias heading into that particular expiration. Have you seen such an indication from the mirror-image puts and calls?

I wish it were that easy. Playing the expiration effect is one of the most difficult pursuits known to the index player.

Everyone knows that the reason for expiration volatility is the unwinding of arbitrageur positions. Practically no one knows, however, exactly how the process works or how to forecast the upcoming expiration effects.

No one but the arbs, of course, really know what they need to do to unwind, but understanding the possible scenarios can give the savvy Option Fool an edge to playing the expiration. It will take several columns (to say the least) to cover the subject, but let’s start chipping away at it.

First off, let’s break the material up into 3 categories:

1) Pre-expiration Effect
2) Expiration Day Itself
3) Post-Expiration Effect

BTW, you can spend the rest of your life studying expiration week patterns and still not see every possible scenario. It is a hopelessly complex area but more fun than any other time of the month. As always, use only pure risk capital and treat it like a trip to the casino. In fact, several sharpies I know ignore the markets completely during the rest of the month and bring in their wallets only on expiration day itself. Don’t laugh, that strategy is not as silly as it seems.

Since you ask about the behavior of options as a predictive indicator to the expiry, I’ll dedicate this column to the first subject, the Pre-expiration effects.
Readers have been noting that there have been strong rallies in the week of expiration, with real bang-up closes on Wednesday or Thursday. Yes, these moves are
caused by the arbs, as I will explain.

The usual arb play is called “Riskless Index Arbitrage”.
In the interest of keeping the Option Fool reader awake, I will only hit the highlights. You arbs on the mailing list will please bear with me if I oversimplify or omit something crucial. Basically, the arb will establish a position that will consist of short stock hedged by long OEX calls and short OEX puts. The stocks involved will duplicate exactly the makeup of the OEX Index. This position is often set up in a orderly rally when it is easy to short stocks and buy calls cheap (as compared to a spike where call premiums are outrageous).

As the expiry nears, the arb can do one of two things:

1) Unwind at the expiration itself, or
2) Unwind the position before it expires by trading in the
open market.

Traditionally, the first method is used. In it, the arb buys back all the short stock at the close of trading (using Market On Close orders) which equals buying the OEX Index at the closing print. He would also exercise the long calls which cash settle versus that closing OEX value. This technique is riskless, hence the name Riskless Index Arbitrage.

For the more risk tolerant arb, choice 2 offers the possibility of greater profits. The arb will have to work a little “english” into the market, but if conditions are right, that is not hard to do. Here’s how:

Remember, the arb is short OEX stocks, long OEX calls and short OEX puts coming into expiration week. He’ll need to buy stock and exercise his call options. Instead of doing it all at the last moment on Friday as in Scenario 1, he may chose to do it a day or so before. Let’s say it is 3 pm on Wednesday or Thursday and the market is rising (or otherwise acting in a way such that the arb feels he can “gun” the market). He will start buying the stocks to cover his shorts. He’ll do this in a loud fashion, so that the rest of the market sees and hopefully follows.

The goal is to rocket the market up into the close. The crafty arb will time his buying during this last hour to create the maximum effect. He wants the final print in the OEX to be the high. This is, of course, to his advantage because he will exercise the calls (which will cash settle according to the OEX close).

He has created his own excitement and, in doing so, was able to cover his shorts at a lower price (before the big rally he has created) and exercise his long calls for a greater worth (at the very high closing OEX level). He has unwound his arbitrage at greater profits than in method 1.

One can tell, after the fact that such a pre-expiration effect has occurred because of the telling footprints left by such a maneuver. There will be huge exercises/assignments of calls on that Wednesday or Thursday night. Of course, with such artificial pressure exerted at the close (often you’ll see the strategy push the Dow 50 points or so), the next morning will be weak.

The truly cagey arb will have some shorts left over for just that effect. He’ll cover his remaining shorts at the next morning’s lower prices. Truly, this is one of Wall Street’s greatest manipulations. It is take, take, take all the way. If you want your share, you must figure out how the arbs are stacked up and ride along.

That brings us back to your original question: Just how to ascertain the arb’s unwinding needs. Is it in watching the mirror-images as you suggest? That’s interesting but I think we need more than that. Recently, Larry McMillan has looked into the study of open interest of the in-the-money options as an indicator. Results of that approach look promising. Keep in mind, however, that one needs to look at the S&P futures activity also to try to guess at the intentions of the arbs. If the arb activity centers around futures contracts, the effect on stocks may be quite different.

Last month, which was a triple witching, saw all kinds of huge open interest in SPX calls. The media and most traders were clamoring to set up for powerhouse expiration. Of course, as contrary theory would have forecast, nothing happened. All that open interest was set up against the futures. It turned out to be quite a lame expiration. The arbs must have been laughing their heads off. (Larry Mac was correct about the situation, BTW. When brought to his attention, his first concern was that it was futures related.)

The traditional way of trying to figure the arb play is through trading floor sources. Rumors, leaks, and those “in the know”, sometimes can give us an indication. It is important that the trader realize the arbs have about a zillion tricks in their arsenal. Not every month do they
need to do the same thing. The above mentioned “Riskless Index Arbitrage” is not done month after month. It depends on market conditions in the weeks preceding. There may be better hedge plays in the futures or elsewhere.

The savvy Option Fool should try to learn as many expiration plays as possible so that he knows what to do in the unlikely case of lucking on to the true intentions of the arbs (In which case, that Option Fool better let me in on it as well!!).

Topic: Playing Expiration Day Itself Part 2 of 3

Nice job on the pre-expiration effect. How does one know if rallies early in the week are attributable to the arbs? If there is a 20 point rally on Thursday, does this mean that the arbitrageurs are out of ammo for expiration day itself?

As mentioned in the previous column, “The Pre- Expiration Effect”, one should look for the tell-tale footprints of arb induced activity. First off, the public customer should keep his ears tuned to his broker and the financial media (although both may be unreliable at
times). To verify what one hears, the ever-suspicious Option Fool should check things out himself. How?

I mentioned use of the open interest figures. Starting at the beginning of expiration week (actually, say Tuesday), keep track of the in-the-money OEX calls. I would start not with the first strike in, but the second (e.g. if OEX is at 578, look at 570 and deeper) because the deeper in- the-monies are what the arbs use for hedging purposes. Log the open interest figures for each strike and add them up. Then watch these numbers as the expiration

Some months you will see low figures which will mean that the arbs do NOT have the sufficient firepower to rocket the expiry. You should skip the expiration plays for those months. No fireworks will occur. Other months will show a preponderance of open interest which may mean something exciting can happen. It could mean the Pre-Expiration Effect (early unwinding) as discussed yesterday, or, if the open interest remains high coming into Friday, it may mean the more traditional end of expiration day run-up on Friday’s close.

If the open interest figure drops way off, something has been offset by the arbs. If it was the Pre-Expiration Effect, you should already have known it. If nothing seems to have happened in the market, the arbs may have rolled out of the current month options and into the next month. Again, wait till next month to try something. Your brokerage firm’s floor sources should know if a lot of “rolling” occurred. The point is that you will know to ask by your study of the open interest figures.

How to get the open interest figures? Not exactly easy. The financial papers do not list the open interest totals for each option series (heck, they don’t even list each options series!). Your quote machine (or your broker’s) should be able to tell you. Don’t have one? That is
actually a blessing, if you don’t have live quotes, you shouldn’t be fooling around at expiration anyway.

What do the numbers mean? Well, recent work by McMillan gives him this general rule: 40,000 contracts can move the OEX 1.00 point at the close. You’d do well to memorize that relationship.

The other tell tale sign of the Pre-Expiration Effect that I have mentioned is the huge OEX call exercise that goes on. You can track that effect yourself by calling the OCC, the Options Clearing Corp. They run a recorded message that gives the exercise figures from last night.
The number is (312) 786-7955 (menu choice #5). Note: This telephone number is a VALUABLE resource to tuck into your Option Fool toolkit. Not many know about it.

If there was an early run-up at the close of Wednesday or Thursday with a drop in open interest and large amounts of call exercises, then chalk up another Pre-Expiration
Effect. If you don’t see such an effect, AND YOU KNOW FROM YOUR WORK THAT THE POTENTIAL FOR AN ARB UNWINDING EXISTS, then looks for the traditional effect on Expiration Day itself.

As explained in the first article in this series, the “Riskless Index Arbitrage” play has the arb in need of buying a basket of OEX stocks to cover his shorts at the close. He will then exercise his long OEX calls which cash settle at that closing OEX print. The usual way to play this effect is to buy OEX calls as the last hour of trading approaches and hope for a really big unwinding
at the close. The more conservative (and sophisticated) trader may hedge this purchase by shorting S&P futures against it.

So let’s say you suspect something is going on and you buy some OEX calls at 3 pm. What now? Well, the next thing to look for is the MOC indication. At around 3:30 or 3:45, the exchanges will print the Market On Close size indications. If they are on the buy side, your calls will jump right then and there.

The question is, do you take profits then, or hold through the close? The more conservative player should lock up the profit right away. Many times the actual runoff is not as dramatic as hoped and the buyers of out-of-the-money call buyers will see their options expire worthless (The same contracts that jumped a dollar with the MOC indications).

When the holding strategy works out, however, the results are unbelievable. I have seen 4pm runoffs that brought OEX calls worth 1/4 at 4 pm to 4 1/2 by 4:10pm! Keep your cool - those expirations are far and few between. In fact, lately, the arbs have not been doing this traditional effect
at all, preferring the excitement of an early unwinding.

Regardless of when the unwinding buying takes place, the effect itself causes a vacuum on the downside that usually needs to be filled. The old rule of thumb is to sell the market after a big up expiry, but we’ll look into that in the next installment, Post-Expiration Effects.

Topic: The Post-Expiration Effect Part 3 of 3

I’m a real expiration fool too, but with a twist! I like to wait for late expiration day rallies and then go the other way at the closing bell by buying the next-month puts.
What do you think?

Contrary at the Close

Many players feel, as you do, that the market often goes the other way after a big expiration related move. If the market tanks, they’ll buy calls for a bounce on Monday and Tuesday. Likewise, if the arb buying causes a wild rally during expiration week, the game is to play puts for the next week.

These traders are basically right in their thinking. McMillan has studied past arb influenced expirations (see Larry’s market letter - The Option Strategist - of August 24, 1995) and has found that this scenario indeed does occur about 80% of the time. In that issue, Larry develops a trading system based on the Post-Expiration Effect that seems quite sound. An interesting read that you should take another look at if you have it filed away somewhere.

If you want to try the Post-Expiration Effect for yourself, make sure you know what the Pre-Expiration Effect really was. (Re-read Part 1 of this series?) Sometimes the media reports the expirations in strange ways. For example, if we get a classic early unwinding rally at
Wednesday’s or Thursday’s close (Pre-Expiration Effect), the natural reaction on expiration day itself will be in the opposite reaction (that is, down). Reporters may then incorrectly report the action as a down expiration or an arb-selling expiry. The street-wise Option Fool will, of course, know that the arbs did indeed buy and not sell. So, check for yourself and set up your trading for the early part of the next week in the opposite direction of the true expiration effect.

Some things to keep in mind: Many times there is no strong action on expiration week. Stay out of these plays then and trade as you normally would (or better yet, take a few days off). Also, beware of killer up-side markets. We have seen the big bull in action as of late. When
buying gets frenzied and irrational, we may see the expiration buying extend into the next week without pause. Don’t stand in the way - you’ll get trampled. You’ll also feel mighty stupid too. Getting smashed by a bear market seems to be a badge of honor, whereas losing your shirt in a rampaging bull market gets you ridiculed by everyone. Even by little old ladies crossing the street! Anyway, just be careful. Sometimes we need to ignore those 80% figures that Mr. McMillan quotes.

As for the Post-Expiration Effect in specific equities, we see plenty of that too. Years ago, Michael Jenkins (who writes the market letter Stock Cycles Forecast) wrote of a post-expiration Monday/Tuesday effect due to the fact that options actually expire on Saturday. The thinking is a bit convoluted, but I’ll give it a go here. He notes “after option expiration the stocks have a tendency to have severe gyrations from 2pm to 4pm on Monday afternoon,
very often in a completely opposite direction to which the day had been going.”

In many firms, clients are allowed a bit of margin leeway with expiration exercises. If you exercise your options at the close on Friday, and sell the acquired shares of stock
by the close of Monday, your firm may ask only for the day-trading margin involved (which at 25% allows you to pile on much more than if you were to hold the stock longer term). What this means is that many holders of call options that became worthless by the close of
expiration Friday (but still think that the stock can jump on Monday) opt for the “free ride” over the weekend. Dreamers as they usually are, they hope for a takeover or other good news to appear in the next day’s Barrons.

What happens is that the option holder (now turned stock holder) is holding shares of stock on Monday that he must sell for margin purposes by the close. The market makers know of this effect and will start a drive in the market to lower the bids. The undercapitalized free- rider, who has to sell by the close anyway, will be forced out on this afternoon dip or certainly by 4pm. So, the market makers stand by to buy cheap stock from them. After these weak holders sell out, watch out for a big rally!

Jenkins claims that the really big winners usually explode up on the Tuesday after expiration for this very reason. Very interesting.


The upshot of either scenario is the same. If you see a whiz-bang expiration close (up or down) in an index, or a Monday afternoon sell-off in an option stock, consider going the other way. With the whole world bidding in the opposite direction, you can establish the contrary play at a great entry price.

PS. In any of these expiration strategies, there is a lot to be said for taking the quick buck. If you put something on with the intent of holding it a few days, but it suddenly makes money right away, consider taking the cash and running. Luck is a huge factor in these outright
speculations. Don’t let it run out on you.

Remember, if you rush out and buy your honey something, the arbs can never take it away from him/her. Just don’t tell your sweetie where you got the money from! Seriously, don’t match wits with the arbs - they are smarter than you or I. They are paid to be.

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