U.S. stock options expire after market close on the third Friday of every month unless that Friday is a holiday. Trading on and near expiration day can be frantic as hedge fund managers and arbitrage traders offload short-term options and prices shift accordingly. Experienced traders can employ strategic maneuvers to take advantage of volatility and increase returns.
How Options Work
An option is a contract that grants the owner the right to purchase or sell an asset at an established price on or before a set date. Assets used in option contracts include stocks, bonds and commodities. A call option gives the contract owner the right to buy an asset, while a put option allows them to sell an asset. However, the option contract owner is not under any obligation to complete the transaction at the expiration date. She has the option to do so.
Paying to roll the option over into the next month is possible if a trader hasn't chosen a course of action by expiration day. Rolling options allows traders to take a wait-and-see attitude toward their positions. If the option shows signs of improving -- and if that improvement covers the costs of renewal -- a rolling strategy can give an investor some much-needed time. While this strategy can be effective, it can also be costly. The investor can lose more money if the option continues to decline.
Since options trading near the expiration date usually involves a high level of volatility, some traders wait until the last minute to get every possible dollar out of a trade. The flaw in this strategy is that option prices can soar just as quickly as they can plummet. Taking profits when the option reaches a specific price ensures a positive return. While you might miss a price spike, you'll still come out ahead. This strategy may be better for risk-averse investors than gambling on the potential for higher return in exchange for higher risk.
Lapse or Sell?
Taking a loss during expiration week is unavoidable in some cases. An investor may choose to allow the options to lapse rather than sell at a loss. The problem with that strategy is it can result in a total loss. For instance, an investor who pays $100 for an option sees the value drop to $25 just prior to expiration. Educated investors sell the option for $25 and take the $75 loss, rather than allow it to expire and lose the entire $100.
A butterfly spread for call options is a strategy in which the trader buys a call option at one price, sells two at a higher price and buys a fourth at an even higher price. For put options, the trader buys an option at one price, sells two for a lower price and buys a fourth at an even lower price. As expiration day approaches the butterfly spread becomes highly sensitive to movement in prices. Many traders limit their use of butterfly spreads to the most volatile period of the options cycle to maximize their returns.
Living in Houston, Gerald Hanks has been a writer since 2008. He has contributed to several special-interest national publications. Before starting his writing career, Gerald was a web programmer and database developer for 12 years.