These days, there are lots of different options expirations available, so no single expiration is quite as important as it may have been in the past when availability was much more limited. Even so, some options expiration dates, such as September 20, 2014 are more significant than others because they coincide with expirations of other derivative contracts, namely futures.

When the expirations of options and futures coincide – generally on the third Friday of March, June, September and December – the effect on the stock market can be magnified. The term witching is often used synonymously for the final hour of expiration. Triple-witching or quadruple-witching simply refers to the number of options or futures expiring at the same time.

Witching occurs this Friday, September 20.

To understand the potential effects of witching this week, it may be helpful to take a look at the reasons that options expiration can affect stock prices. Once the reasons are known, it should become easier to notice the effects, thus allowing trader to differentiate those effects, which are generally temporary, from the effects of broader-market forces, which may be more permanent.

Nobody likes to be stopped out of a stock during witching only to have the stock reverse when the effect of witching disappears the following week. The following analysis looks specifically at this Friday’s options witching on the S&P 500. To begin, it is important to know what types of options are currently profitable.

Click on chart to enlarge

* All profits are calculated at expiration, as a percentage of the underlying SPY share price. SPY is an Exchange Traded Fund (ETF), the SPDR S&P 500 ETF Trust (NYSEARCA:SPY) that closely tracks the performance of the S&P 500 stock index. All options are at-the-money (ATM) when-opened 4 months (112 days) to expiration. (e.g. Profit of $6 per share on an expiring Long Call would represent a 3% profit if $SPY was trading at $200, regardless of whether the call premium itself actually increased 50%, 100% or more)

You are here – Bull Market Stage 1 – the “Digesting Gains” Stage.

Click on chart to enlarge

On the chart above there are 3 categories of option trades: A, B and C. For this past week, ending September 6, 2014, this is how the trades performed on the S&P 500 index ($SPY):

• Covered Call and Naked Put trading are each currently profitable (A+).
  This week’s profit was +2.6%.
• Long Call and Married Put trading are each currently profitable (B+).
  This week’s profit was +1.9%.
• Long Straddle and Strangle trading is currently not profitable (C-).
  This week’s loss was -0.8%.

Using the chart above, it can be seen that the combination, A+ B+ C-, occurs whenever the stock market environment is at Bull Market Stage 2, known here as the digesting gains stage. This stage gets its name from the tendency for stocks to experience periods of gains interspersed with significant pullbacks, as if traders are taking time to digest each individual gain. Digestion is often bullish, but not nearly as bullish as the lottery fever of Stage 1 of recent weeks.

It is important to note that a return to lottery fever often cannot be confirmed until it has been in place for at least a week. Thus, the S&P would need to rally this coming week (ending Sept. 20) as well as the following week (ending Sept. 27) in order for a new case of lottery fever to be confirmed.

A chart describing all of the different Options Market Stages is available by clicking the link at the left.

Think like an Option Trader

To understand the effects of option expiration (witching) requires empathy for option traders – a valuable exercise even for stock traders who’ve never traded a single option. Consider the following:

• How would I feel if I sold Naked Puts (or Covered Calls) and stock prices fell below the strike price going into expiration?
• What about if I sold Naked Calls (or Covered Puts) and stock prices rose above the strike price?
• What if I bought Calls or Puts and they ended up in-the-money (ITM) near expiration?

Let’s start with that last one. Most likely if a trader buys Calls it is because there is an expectation that the stock price will rise. It is true Long Calls may also be used as protection for short stock position, as a sort of stop loss. However, in general a buyer of a Call expects to profit when the share price rises by using the Call to purchase shares of stock at a bargain price (the strike price) when the stock price has moved higher.

For example, if I buy one standard Call option at the $100 strike price and the stock price rises to $105, I can exercise that Call option and buy 100 shares of stock for $100 a share, even though it is trading at $105 per share on the open market. That’s a bargain! Even if I don’t necessarily want to own the stock, I can use the Call option to buy the stock at a bargain and then sell it on the open market for an instant $5 profit (although profit is reduced by the cost of the Call option of course).

The same is true if the stock price falls below the strike price and I own a Put option. For example, if I buy one standard Put option at the $100 strike price and the stock is trading at $95 on expiration day, I can exercise the Put option and sell 100 shares of stock at $100 even though it is trading at only $95 on the open market. That’s a bargain too! Even if I don’t own the stock, I can buy it on the open market for $95 and use the Put option to sell it at the strike price of $100, an instant $5 per share profit (although profit is always reduced by the initial cost of the Put option).

In either case, if I own a Call or a Put and the strike price is out-of-the-money at expiration, the option is worthless. There is no bargain in exercising a $100-strike Call option if the stock price is $95, just as there is no bargain in exercising a $100-strike Put option if the stock price is $105. Out-of-the-money options are worthless when they get to expiration. The only reason they ever have value is because they might be worth something someday. When expiration day arrives, the time is up; therefore on expiration day all out-of-the-money options lose whatever remaining value they might have.

Out-of-the-money (OTM) Options at Expiration

Out-of-the-money options become worthless on expiration day, and that’s great for the folks who sold such options because they get to keep whatever premium was collected. For example, if I sell a $100-strike Call option for $2 per share, and the stock price subsequently falls to $95 on expiration day, the option will become worthless and I will keep the $2 per share premium. That’s great for me – not so great for whoever bought that particular option from me.

If I buy an option and it is out-of-the-money at expiration, I lose any chance of recovering the cost of that option because time has run out – the option is worthless, permanently. When a trader buys an option that expires worthless, the result is a loss on the option. Even so, the loss on the option is limited. The buyer of an option can never lose more than the initial premium paid. If I buy a Call option for $2 per share, my loss can never be greater than $2 per share because the absolute worst thing that can happen is for the option to go to zero, if it expires out-of-the-money, worthless.

Out-of-the-money options at expiration give option sellers a limited gain, since their gain is limited to the premium they collected. OTM options give option buyers a limited loss at expiration, since their loss is limited to the premium they paid. In either case, whether buyer or seller, the gain or loss is limited; thus OTM options are not likely to induce major changes in stock prices at expiration. Major changes tend to come from traders trying to limit their losses, something that doesn't much affect either buyers or sellers of OTM options on expiration day.

In-the-money (ITM) Options at Expiration

In-the-money options are good for buyers when expiration day arrives. One standard ITM Call option at expiration will cause the owner of that option to automatically buy 100 shares of the underlying stock. The price per share will be the strike price of the Call; and the strike price is always lower than the current share price when a Call is ITM.

There is no compelling reason for the ITM Call owner to take any action at expiration, unless he or she does not want to own the stock. But, in the case in which stock ownership is not desired, the Call can be sold before it expires, often at a profit, rather than taking possession of 100 shares of stock and then selling those shares at a profit. The owner of an ITM Call therefore does not normally influence the stock market to any great degree on expiration day, because he need not trade any shares of stock to go long (he just keeps the Call open) and he need not trade any shares of stock to close his long position (he just closes the Call).

One standard Put option at expiration will cause the owner of that option to automatically sell 100 shares of the underlying stock at expiration. Again, the owner has the ability to sell the option before it expires in-the-money, thus avoiding unwanted exercise and the sale of 100 shares of stock. The owner of an ITM Put, therefore has little influence on the stock market at option witching. He just keeps the Put open to close a long stock position or to initiate a short, or else closes the Put to remain long or to avoid going short on the stock - either way, no shares need be traded before expiration occurs.

There are a few ways ITM option owners may have a minor effect on stock prices on expiration day. Option exercise can result in large capital requirements, so traders may short stock in a rally near expiration to make room for shares that will be obtained by exercising an ITM Call option. Some may buy shares in a sell-off near expiration in order to sell those shares by exercising an ITM Put option.

In either case, Holders of ITM options may thus reduce volatility slightly on expiration day, since shorting stocks on a rally (to make room for shares from a Call exercise) can add selling pressure that may limit the rally while buying stocks on a sell-off (to obtain shares for a Put exercise) can add buying pressure that may limit the sell-off, but the limiting effect is generally small. In most cases, such stock trading is only required when liquidity has dried up on the ITM options, making it impossible for the option holder to simply sell the option, at least not at a fair price. If liquidity is good, the option is usually easier to sell than to exercise.

The seller of an ITM option may have the biggest influence of all on expiration day, and here’s how. Option sellers, also called option writers, have no say in whether the options they sold will get exercised and assigned. Exercise is the buyer’s decision – the buyer’s option. That’s why they are called options.

For the seller, the option is actually an obligation. A seller of one standard Call option is obligated to sell 100 shares of stock on expiration day, at the strike price, if that option expires in-the-money. The shares will simply be called out of his account.

The seller of one standard Put option that is ITM at expiration is obligated to buy 100 shares of stock at the strike price. The shares will simply be put into his account.

Because of this obligation, it behooves sellers of ITM options to take steps to ensure their account is prepared to either have shares called away, or shares put in it on expiration day. The simplest way for a Call seller to prepare to have shares called away is to buy sufficient shares on expiration day to meet the obligation; and the simplest way for a Put seller to prepare is to short enough shares on expiration day to make room for those that will be put on him.

Witching Hour

An expanded 10-year historical chart is now available.

By the time the final hour of trading has arrived on the third Friday of March, June, September or December, most of the attention in the stock market is focused on traders meeting their obligations.

Options sellers often must short shares if stock prices have fallen unexpectedly, in order to make room for shares about to be put on them from ITM Put options. If stock prices are up unexpectedly, they may need to purchase shares to meet their obligation by having enough shares on hand to have them called away.

Whether stock prices are down or up, the obligations of option sellers tends to magnify the trend. Selloffs can become magnified by Put sellers shorting shares to make room for those about to be put on them. Rallies can be magnified by Call sellers buying enough shares to have some called away. This is especially true when stock prices make a large move on expiration day, causing option sellers at OTM strikes to suddenly find themselves ITM and in dire need of enough long or short shares to either meet their obligation (short Calls) or make room for delivery (short Puts).

As mentioned previously, major changes at option witching tend to come from traders trying to limit their losses - sellers of Calls buying shares to limit losses when stocks shoot higher, sellers of Puts shorting shares to limit losses when stock prices tumble. Option owners can just sit on their profits if they suddenly find themselves ITM at witching.

On witching Friday:

• OTM buyers have no immediate need to trade stock since their loss is at a maximum and cannot increase at expiration
• OTM sellers have no immediate need to trade stock since they will experience maximum gains at expiration
• ITM buyers have no immediate need to trade stock since they will experience a gain on the stock at expiration
• ITM sellers do have an immediate need to trade stock since it may be the only way to cut losses let alone meet option obligations

September 19, 2014 3:00 PM EDT

When the witching hour begins this week, option sellers will need to take the steps outlined above if their positions are in-the-money. Since the trend has largely been upward for the past several months leading into Friday’s expiration, many Call options that were initially opened OTM – some may have been opened several months ago - will likely be ITM. Of those ITM Calls, many will likely be closed before Friday, if they were not already closed weeks ago.

The S&P 500 has risen nearly 100 points in the past 4 months, so a lot of Call option strike prices that were out-of-the-money at that time are now in-the-money. A lot of Put options that were in-the-money or at-the-money are now out-of-the-money. The question this Friday is whether all the remaining OTM Call sellers will suddenly find themselves in-the-money and therefore in need of long shares, possibly driving a rally to new all-time highs. Or, it’s a question of whether the remaining OTM Put sellers will suddenly find themselves in-the-money and in need of short shares, possibly driving the sell-off even deeper.

As can be seen in the chart above, if stock prices climb above the blue line (currently near the 2020 level for the S&P) by Friday then it would likely take a lot of OTM Call sellers by surprise and they might be forced to hastily buy shares when their Calls end up ITM, which could drive a return to Bull Market Stage 1 “Lottery Fever” and set stocks up for new record highs in the S&P in the coming weeks.

If stock prices fall below the yellow line (currently near the 1972 level) by Friday then it would likely take a lot of OTM Put sellers by surprise and they might be forced to short shares when their Puts end up ITM, which could drive a return to Bull Market Stage 3 “Resistance” and set stocks up for a brick wall of resistance for the S&P in the coming weeks, at the recent high near the 2010 level.

Weekly 3-Step Options Analysis: 

On the chart of “Stocks and Options at a Glance”, option strategies are broken down into 3 basic categories: A, B and C. Following is a detailed 3-step analysis of the performance of each of those categories.

STEP 1: Are the Bulls in Control of the Market?

The performance of Covered Calls and Naked Puts (Category A+ trades) reveals whether the Bulls are in control. The Covered Call/Naked Put Index (#CCNPI) measures the performance of these trades on the S&P 500 when opened at-the-money over several time frames.

Most important is the profitability of these trades opened 112 days prior to expiration, which balances sluggish responses of longer expirations with irrelevant noisy responses of shorter expirations.

 

Covered Call trading did not experience a single loss in 2013, and the streak endures so far in 2014, continuing a streak of nearly lossless trading extending all the way back to late 2011. That means the Bulls have been in control since late 2011 and remain in control here, nearly 3 full years later, in 2014.

As long as the S&P remains above 1875 over the upcoming week, Covered Call trading (and Naked Put trading) will remain profitable, indicating that the Bulls retain control of the longer-term trend. Below S&P 1875 this week, Covered Calls and Naked Puts will not be profitable, and since such trades only produce losses in a Bear market, it would suggest the Bears were in control.

The reasoning goes as follows:

•           “If I can sell an at-the-money Covered Call or a Naked Put and make a profit, then prices have either been going up, or have not fallen significantly.” Either way, it’s a Bull market.

•           “If I can’t collect enough of a premium on a Covered Call or Naked Put to earn a profit, it means prices are falling too fast. If implied volatility increases, as measured by indicators such as the VIX, the premiums I collect will increase as well. If the higher premiums are insufficient to offset my losses, the Bulls have lost control.” It’s a Bear market.

•           “If stock prices have been falling long enough to have caused extremely high implied volatility, as measured by indicators such as the VIX, and I can collect enough of a premium on a Covered Call or Naked Put to earn a profit even when stock prices fall drastically, the Bears have lost control.” It’s probably very near the end of a Bear market.

STEP 2: How Strong are the Bulls?

The performance of Long Calls and Married Puts (Category B+ trades) reveals whether bullish traders’ confidence is strong or weak. The Long Call/Married Put Index (#LCMPI) measures the performance of these trades on the S&P 500 when opened at-the-money over several time frames.

Most important is the profitability of these trades opened 112 days prior to expiration which balances sluggish responses of longer expirations with irrelevant noisy responses of shorter expirations.

 

Long Call trading became unprofitable this past March, Those losses intensified during April and early May before reverting back to profits in recent weeks and months. Losses for Long Calls are a sign of weakness for a Bull market. Such weakness can be dangerous because it lowers the perceived reward potential for stock owners, which makes stocks less attractive, in turn lowering the price stock sellers are able to obtain from buyers.

As long as the S&P closes the upcoming week above 1972, Long Calls (and Married Puts) will remain profitable, suggesting the Bulls retain confidence and strength. Below 1972, Long Calls and Married Puts will not be profitable, which would suggest a significant shift in sentiment, notably a loss of confidence by the Bulls. Confidence and strength show up as a “buy the dip” mentality, while a lack of confidence and strength produces a “sell the rip” sentiment that tends to set recent highs as brick-wall resistance, since each test of that high is perceived as a rip to be sold.

The reasoning goes as follows:

•           “If I can pay the premium on an at-the-money Long Call or a Married Put and still manage to earn a profit, then prices have been going up – and going up quickly.” The Bulls are not just in control, they are also showing their strength.

•           “If I pay the premium on a Long Call or a Married Put and fail to earn a profit, then prices have either gone down, or have not risen significantly.” Either way, if the Bulls are in control they are not showing their strength.

STEP 3: Have the Bulls or Bears Overstepped their Authority?

The performance of Long Straddles and Strangles (Category C+ trades) reveals whether traders feel the market is normal, has come too far and needs to correct, or has not moved far enough and needs to break out of its current range. The Long Straddle/Strangle Index (#LSSI) measures the performance of these trades on the S&P 500 when opened at-the-money over several time frames.

Most important is the profitability of these trades opened 112 days prior to expiration, which balances sluggish responses of longer expirations with irrelevant noisy responses of shorter expirations.

The LSSI currently stands at -0.8%, which is normal, and indicative of a market that is neither in imminent need of correction nor in need of a major breakout from the trading range of the last few months. Negative values for the LSSI represent losses for Long Straddle option trades. Small losses are quite normal and usual for Long Straddle trading.

The 3 unusual conditions for a Long Straddle or Long Strangle trade are:

• Any profit
• Excessive profit (>4% per 4 months)
• Excessive loss (>6% per 4 months)

Long Straddle trading (and Long Strangle trading) will not be profitable during the upcoming week unless the S&P closes above 2020. Values above S&P 2020 would suggest a continuation of the recent euphoric “lottery fever” type of mentality that tends to lead to a rally for stock prices.

Excessive Long Straddle trading profits (more than 4%) will not occur unless the S&P exceeds 2097 this week, which would suggest absurdity, or out-of-control “lottery fever” and widespread acceptance that stock prices have risen too far too fast for the rate to be sustainable, thus needing to correct in order to return to sustainability.

Excessive Long Straddle losses (more than 6%) will not occur unless the S&P falls to 1905 this week. Since excessive losses tend to coincide with a desire for traders to make stock prices break out, either higher or lower than the boundaries of their recent range, a break higher from 1905 would be a major bullish “buy the dip” signal, while a break below 1905 would signal a full-fledged Bull market correction was underway.

The reasoning goes as follows:

•           “If I can pay the premium, not just on an at-the-money Call, but also on an at-the-money Put and still manage to earn a profit, then prices have not just been moving quickly, but at a rate that is surprisingly fast.” Profits warrant concern that a Bull market may be becoming over-bought or a Bear market may be becoming over-sold, but generally profits of less than 4% do not indicate an immediate threat of a correction.

•           “If I can pay both premiums and earn a profit of more than 4%, then the pace of the trend has been ridiculous and unsustainable.” No matter how much strength the Bulls or Bears have, they have pushed the market too far, too fast, and it needs to correct, at least temporarily.

•           “If I pay both premiums and suffer a loss of more than 6%, then the market has become remarkably trendless and range bound.” The stalemate between the Bulls and Bears has gone on far too long, and the market needs to break out of its current price range, either to a higher range or a lower one.

*Option position returns are extrapolated from historical data deemed reliable, but which cannot be guaranteed accurate. Not all strike prices and expiration dates may be available for trading, so actual returns may differ slightly from those calculated above.

The preceding is a post by Christopher Ebert, co-author of the popular option trading book “Show Me Your Options!” He uses his engineering background to mix and match options as a means of preserving portfolio wealth while outpacing inflation. Questions about constructing a specific option trade, or option trading in general, may be entered in the comment section below, or emailed to OptionScientist@zentrader.ca

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