Things to consider when trading near expiry date

Exchange Traded Options (ETO's) are used for a variety of reasons.

* You can protect your shares from a fall in price through the use of put options.
* Earn income against the shares you hold by writing (selling) covered calls options against the stock. If you are looking to buy a particular stock you can write 'naked' put options which will earn you a cash premium but oblige you to buy the stock at the strike price.
* Increase your returns through leverage. The leveraged nature of Options means that with the a small amount of money you can increase your exposure to the underlying security.
* Finally you can diversify your portfolio with options, with a limited amount of capital you can increase your exposure to a variety of securities, albeit for a set amount of time.

In this case, we wish to focus more on the trading aspect of using options to generate a trading income, especially approaching an option's expiry date.

Option expiry date
All options are issued with an expiry date. The expiry date is the day on which all unexercised options in a particular series expire and is the last day of trading for that particular series. The typical life of a stock option varies, when created the expiry date can be years away however they are normally most heavily traded during the last few months to expiry. The stock option expiry date is always the Thursday before the last business Friday of every month. So the dates for expiry until the end of the December 2007 are:

* 24 May 2007
* 28 June 2007
* 26 July 2007
* 30 August 2007
* 27 September 2007
* 25 October 2007
* 29 November 2007
* 20 December 2007

A complete list of expiry dates up until 2012 can be found on the ASX website.

So what are the risks of trading options near the expiry date?
As the price of a stock option is affected by stock price volatility, especially for options trading near-the-money. The closer an option is to expiry, the lower the extrinisic (time) value. (The relationship between the Intrinsic and extrinsic value of an option is detailed in the knowledge bank and can accessed here.).

It follows that on expiry day, if the share price is close to or at a particualr strike price, the price of that option will be mostly determined by the intra-day movement of the underlying share price. As such, high price volatility in the share price will be mirrored by the option price. This can make for dangerous speculative option trading with ETOs that are about to expire, as the leverage can be amplified.



Example
The following example occurred in 2006 on the June expiry date.



As you can see from the intra-day chart for ANZ Banking Group (ANZ) above, the share price made a strong recovery from a soft start. The $25.42 July Put option was trading at 44c at 10.20am but by 3pm it was trading at 2c. This is a 95% adverse movement for those speculative option traders who bought into the put contract in the morning and did not, or were not able to exit. This reflects the loss of intrinsic value. However, the ANZ August $25.00 Put with a month to run before expiry decreased from 60c to 40c. A much smaller percentage decrease.

It has been suggested that there is some gentle massaging of stock prices around strike prices with large open interest on the expiry date. However, often we find that prices will settle back towards more market detemined levels the following day when this artifical buying or selling is removed from the market. Addtionally, as the exercises and assignments of option contracts are settled though the market the following day, we generally see higher than normal share trading volumes on the Friday subsequent to the expiry date.