Last Updated on 3 November, 2022 by Samuelsson
Options contracts in the US market expire on the Friday before the 3rd Saturday each month, and there has been this notion that the equity market performs differently during the options expiration weeks. Is this options week anomaly real or not? This is what we are set to find out.
A test of the options expiration week effect shows that the S&P 500 Index made positive returns during the options expiration week, except in July and January, which had negative returns during the options expiration week, and April was by far the best month. By and large, the options expiration week effect seems to be real. But before we show you the results of our tests, let’s first explore the basics. While there are options on different assets, we will focus on US stock options in this article.
Options expiration week: what is it?
US-listed stock options expire on the third Friday every month — more precisely, the Friday before the 3rd Saturday of the month — except when Friday is a public holiday, in which case the expiration date becomes the trading day (Thursday) before that Friday.
When the options on stocks, stock index futures, and stock index options all expire on the same day, the expiration week quad witching options expiration week. This happens four times per year — in March, June, September, and December.
Here’s what happens when an option expires
Stock options are derivative contracts that give the buyer the right (not obligation) to buy (call option) or sell (put option) a determined quantity of stocks at a specified price (strike price). These contracts expire after some time, unlike equities that, unless the company is bankrupt, merged, or bought by some other company, have theoretically an infinite life.
For instance, let’s say an investor is selling Apple stock (Nasdaq: AAPL) call options with a strike of $150 with an expiry date of the 14th of January 2022, while the share price today (October 8, 2021) is $142.90. The buyer of the call option pays a premium to the seller to gain the right to purchase shares of Apple stock at $150 on or before the expiry date of 14th of January 2022. After that date, the option expires and literally ceases to exist.
Before that expiration date, if the price of Apple stock is higher than the $150 strike price, the owner will exercise the option and buy at $150 and would make a profit by selling at the current market price. However, if the price is less than $150 at the expiry date, the option expires worthless because it doesn’t make sense for the buyer to buy at $150.
Thus, the price of the options varies significantly from how a share price is valued. Since the value of an option can be influenced by both the time to expiry and the volatility of the underlying stock, options price movement (premium) can be substantially different from the underlying stock.
How do options expiration affect stock prices?
The time to expiry does affect the price of the underlying stock because the closer to options expiration, the higher the risk of delivery. The effect on the stock price is especially seen on the last trading day before expiration.
Trading imbalances on the options expiration day
Those who day trade stocks know that the option expiration days are often lucrative because of imbalances. On such days, both the market open and the close have imbalances that can be preyed on. The theory is that “pin risk” causes a significant increase in trading activity, leading to more imbalances.
Options expirations and pin risk
Pin risk refers to the risk of having to take delivery of the shares when you sell put options. For instance, if you have issued puts with a strike at $150, you are obligated to buy those shares if the share price is lower at expiration. Since many investors won’t want to have the risk of keeping all those shares over the weekend if they get exercised, they tend to sell the shares immediately, which affects the price of the stock (more volatility).
Creating a trading strategy from the options expiration week effect
A simple strategy we can use to exploit the options expiration wee effect could be to buy on the open of the options expiration week or the close of the preceding week and exit on the close of the options expiration day (usually a Friday, but if Friday is a holiday, we exit on Thursday). So, we own the stocks during this expiration week and stay out of the market for the rest of the time.
Our backtesting shows that the results vary depending on when and how we enter. Entering on the open of the Monday of the expiration week gives a different result from entering at the close of the preceding Friday.
We tested the options expiration week effect on the S&P 500 Index because most of the open interest in options is in the large-cap stocks. Our test focused on the period after 1990.
The compounding returns of being only invested in the S&P 500 during the options expiration week is shown in the equity chart below:
Our initial capital was $100,000. The result shows the CAGR to be 3.4%, while the average gain is 0.3% per week, which is higher than trading during any other random week. We were invested only around 10% of the time, and the average number of bars in a trade was slightly less than 5.
Note that if we enter at the close of the trading week preceding the options expiration week, the average gain increases to 0.35% per trade.
With this result, we can conclude that the options expiration week effect is real.
Options expiration week effect for each month
The result per month for $100,000 compounded over the same month throughout the testing duration is as follows:
|Month||Net Profit||Net % Profit||Profit Factor||Exposure %||Number of Trades||Average % Profit|
As you can see, the result differs significantly from month to month. April is the best month, by far, while July and January are the worst.
See how the equity curve of the compounded results for April looks like:
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