The Best Option Trade for Expiration Week
07/23/2012 9:00 am EST
Dan Passarelli explains a time-tested option strategy whose profit potential tends to blossom during the last few days before expiration.
One of the major differences when learning to trade options as opposed to equity trading is the impact of time on the various trade vehicles.
Remember that quoted option premiums reflect the sum of both intrinsic (if any) and extrinsic (time) value. Also remember that while very few things in trading are for certain, one certainty is that the time value of an option premium goes to zero at the closing bell on expiration Friday.
While this decay of time premium to a value of zero is reliable and inescapable in our world of option trading, it is important to recognize that the decay is not linear. It is during the final weeks of the option cycle that decay of the extrinsic premium begins inexorably to race ever faster to oblivion.
In the vocabulary of the options trader, the rate of theta decay increases as expiration approaches. It is from this quickening of the pace that many examples of option trading vehicles gain their maximum profitability during this final week of their life.
Some of the most dramatic changes in behavior can be seen in the trading vehicle known as the butterfly. For those new to options, consideration of the butterfly represents the move from simple single-legged strategy, such as simply buying a put or a call, to multi-legged strategies that include both buying and selling options in certain patterns.
To review briefly, a butterfly consists of a vertical debit spread and vertical credit spread sharing the central strike price constructed together in the same underlying in the same month. It may be built using either puts or calls, and its directional bias derives from strike selection rather than the particular type of option used for construction. For a (long) butterfly, maximum profit is always achieved at expiration when the underlying closes at the short strike shared by the two vertical spreads.
The butterfly has the interesting functional characteristic that it responds sluggishly to price movement early in its life, for example in the first two weeks of a four-week option cycle. However, as expiration approaches, the butterfly becomes increasingly sensitive to price movement as the time premium erodes, and the beast becomes increasingly subject to delta as a result of increasing gamma.
It is for this reason that many butterfly traders restrict their use to the more responsive part of the options cycle. For a butterfly, the greatest sensitivity to time (and, therefore, profit potential) is reaped in the final week of the life cycle of the butterfly, i.e. expiration week.
One of the greatest advantages of options trading is its extreme flexibility in both the initial construction of positions and in the ability to adjust a position to match the outlook of the underlying.
The trader who limits his world to that of simply trading equities and ETFs can only deal in terms of short or long, and the change of a thesis often requires starting anew in the position. The options trader can usually accommodate the newly developed thesis much more fluidly, often with minor adjustments on the position in order to achieve the right fit with the new worldview.
One concept with which the trader needs to be familiar in order to orchestrate the necessary adjustments is that of the synthetic relationships. Most options traders neglect to familiarize themselves with the concept when learning to trade options.
This concept arises from the fact that appropriately structured option positions are virtually indistinguishable in function from the corresponding long or short equity/ETF position. One approach to remembering the relationships is rote memorization of the relationships. I find remembering the mathematical formula and modifying as needed to be much more useful.
For those who remember high school algebra, the fundamental equation expressing this relationship is S=C-P. The variables are defined as S=stock, C=call, and P=put. This equation states that stock is equivalent to a long call and a short put.
Using tenth-grade algebra to formulate this equation, the various equivalency relationships can easily be determined. Remember that we can maintain the validity of the equation by performing the same action to each of the two sides. This fundamental algebraic adjustment allows us, for example, to derive the structure of a short stock position by multiplying each side by -1 and maintain the equality relationship. In this case (S)*-1 =(C-P)*-1 or —S=P-C; short stock equals long put and short call.
Such synthetic positions are frequently used to establish positions or to modify existing positions either in whole or part, including a butterfly option spread.
You might have hated math when you were in school, but applying some of the formulas can help an options trader exponentially! Don’t let the math intimidate you. If you start to watch these equations on a regular basis, it will become second nature for you to determine the option trades that offer the best probability for success.
Dan Passarelli can be found at MarketTaker.com.