Sunday, November 25, 2007

The Effects Of Option Expiration On Stock Prices

Here is an excellent post to put in your study guide!

The chart below shows the behavior of Advanced Micro Devices after each option expiration.
The blue lines represent option expiration day.

One of the first things you notice is that about 75% of the time the stock will not make a sizable move until just after the most recent options expire. There is a reason for this, as the market engineers want as many options to expire worthless and by keeping a stocks volatility down in the last week of trading before expiration allows the premium on at and out of the money options to decline sharply. Do you think they might sell the premium?

The second little secret you can use around option expiration to give you an idea as to what direction a stock may move is to look at the open interest in both the puts and calls for the options that will be going off the board. You want to take a look about 5-8 days before option expiration and look for the strike prices that have the highest open interest and notice how the stock price will gravitate in a way to make as many options expire worthless as possible.

For example, if there is a high level of open interest in the at or just out of the money put options then it is a pretty safe bet that the stock price will move higher, away from the strike price, but be also aware of the call option open interest at or just out of the money and you will get an idea of what price range the stock should stay in until after option expiration.

So, with this premise in mind, what would be a good strategy to put into action?

Well, we know the odds are with us that volatility in the stock should remain fairly benign during the last week to 10 days before option expiration, so we could sell premium. Finding the options with the most premium that have very high odds of expiring at or out of the money.

This strategy takes some research and some work, but it also stacks the odds in our favor. Also, not all stocks are created equal. In other words you have to find stocks that have a history of behaving in this manner. You already have one stock in the arsenal with AMD.

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