Tesla, SPX And Quarterly Expiration

Yesterday, we discussed many of the ramifications surrounding Tesla’s (TSLA) addition to the S&P 500 Index (SPX). As lengthy as that article might have been, one point required more clarification than time and space permitted. Today’s piece will go into far more detail about how the index addition might affect tomorrow’s quarterly expiration.

Two unprecedented phenomena will be converging. The index has never added such an immensely large stock at the same time that options volumes and open interest are at record highs. One of my mantras is “every time a stock moves through a strike, someone needs to re-hedge”. Tomorrow we have the potential for many more stocks than normal to do so at the close when re-hedging is difficult or even impossible.

The problem is “pin risk”. Pin risk occurs when someone holds an option that is right around a strike on expiry. It is particularly acute for those who are short options. Options market makers – who hold positions in multiple classes and are more likely to be short options than speculators – are quite concerned with pin risk around expiration, but I doubt that it is fully appreciated by relative newcomers to the options markets.

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Here is an example. Microsoft (MSFT) is just under $220 right now. (Let’s pretend that we’re 5 minutes from expiry, not 2 full trading days). If you are long a $220 call it is out of the money right now, but if it crosses the strike it’s in the money. When you have a while to go to expiration, the delta change would be relatively minimal – say from 40 to 60. The closer you get to expiration, the more binary that becomes. At 3:58 on expiration, the delta of a $220 call with the stock at $219.50 is roughly zero. If MSFT suddenly closes at $220.01 the delta flips to 1. 

This can wreak havoc on traders, leaving them longer or shorter than expected. And it’s much worse if you’re short options. In the example above, the call holder can simply decline to exercise if she doesn’t want to be long MSFT over the weekend. If you are short that call, the decision rests with someone else. It means you don’t really know what your delta exposure will be some time after the exercise deadline

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Disclosure: The analysis in this material is provided for information only and is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the ...

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