How to Trade Options Close to Expiration

11/20/2009 12:01 am EST

Focus: OPTIONS

Kenneth Trester

Editor, Maximum Options

If you are looking for really big, really fast options profits—and, really, who amongst us isn't—then consider buying expiring options.

"But, Ken, aren't expiring options the most risky?" Well, I'm glad you asked.

In some cases the answer is yes, but that risk is due largely to the fact that during the last week before expiration, very close-to-the-money options can make dramatic moves in value very quickly-often within one or two days.

The reward, however, is that buying these kinds of options can generate some of the biggest home runs you'll ever get. And, unlike earnings season, which only happens quarterly, expiration cycles take place monthly, so you get a dozen chances a year to take advantage of these last-minute profit opportunities!

The best options to buy in what I call "expiration plays" are index options, such as options on the S&P 100 Index (OEX). The key to success in this strategy is to buy on weakness in the option price. You should also try to buy options under $1 whose underlying instruments are trading very close to the strike price.

But be forewarned; you can incur a fair number of losses with this strategy, but just one big move in the index price can give you the jackpot of a lifetime. You might try testing these trades on paper for a while to see the results of this type of play.

In expiration plays, you are betting on surprise volatility swinging the price of a stock or index—and, thus, the option—into your favor. And with the current level of volatility, our ability to take advantage of price swings is greater than when the market is trading flat or even when it is climbing predictably.

Turn $12.50 into $100 in Just One Day!

Although I favor index options for expiration plays, that doesn't preclude the power of equity options as a terrific resource. Recently, I was watching shares of IBM Corp. (IBM) move in a three-point trading range each day as expiration Friday approached.

The close-to-the money call (that is, the option with the strike price closest to the market value of the shares) was moving back and forth between a high of $1, all the way down to 12.5 cents, with just two days left before the calls expired.

Seeing this, I decided to enter an order to purchase the call at 12.5 cents, and the order was filled during the day, whereupon I established an order to sell the option at $1. Given the volatility of the trading, with those 85-cent-plus swings, there was a decent chance that this "long shot" could be achieved.

My order was filled a few hours later, giving me a 700% gain.

Had I not entered the sell order, I would have lost my original investment, as the option ended up expiring worthless. Fast action is needed with this strategy, so if you know you'll have the time to monitor your trading account when expiration approaches, this is a great play. But remember, you should only use your "Vegas money"-that is, money you can afford to lose, because often, expiration plays are an all-or-nothing wager.  (Speaking of which, The Traders Expo in Las Vegas is happening right now—hope to see you there!)

During the life of an option, its price is based on a variety of factors, including the underlying instrument's price as well as something called time value. Essentially, time value means that the farther away an option is from expiration, the more time it has to move into profitability and, thus, the more likely it is to become a winner.

As expiration closes in, option values decay much quicker. The deeper in the money the option is, the better the chances it will finish profitably. Buying expiring options that are at the money is more of a risk because an unpredictable day in the markets may mean that the option jumps in your favor or bolts in the opposite direction. The good news is that if you can get in on a dramatic dip, as I did in the IBM example, it would have only cost $12.50 per contract. And for the potential gain of more than $85 per contract, the payoff justified the risk.

MORE: What a Difference a Few Days Can Make

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What a Difference a Few Days Can Make

Can't decide which equity options to invest in as the witching hour approaches? Then take advantage of the volatility in the overall markets by establishing plays on the broader indices.

Using this expiration strategy, I bought some call options on the S&P 100 (OEX) one week before expiration at 38 cents. Then, with three days left before expiration, I had to make an unexpected business trip, so I closed out the position at 75 cents—93% above my purchase price. While that was a terrific return, I could have experienced even more upside, thanks to another spike in the market, in a very short time.

At expiration, the index was trading seven points in the money of the call option. (That is, it was trading $7 above the strike price of the call I had bought.) Had I held on to the position, my gain would have been almost 2,000%!

Keep in mind that if your options have a value of 5 cents or higher (for equities), or one cent or more (for index options), upon expiration, the Options Clearing Corp. allows for a procedure called "exercise by exception," in which your broker can exercise your options on your behalf if you have not instructed him or her otherwise.

In this case, because owning a call option gives you the right to purchase shares at the strike price, your broker would purchase the equivalent number of shares to your options contracts. (That is, if you have ten options contracts, you control 1,000 shares; thus, you would then own those 1,000 shares.) This is why it is important to close your positions or to ensure that your broker knows to close the option and not exercise it.

If you purchase expiring options, make sure to buy the options really cheap, and particularly on weakness, where there is still a fair chance the index or stock price could trade up through the strike price and, thus, move the option in the money.

You need a lot of patience, as well as a high tolerance for losses, to play the expiring options game. And there will likely be many months where you will not find opportunities. However, if the game is played correctly, this long-shot strategy can give you the thrill of some really big rewards.

By Ken Trester, founder, Institute for Options Research

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