Managing an options portfolio at expiration – Part I
By Simon Gleadall, CEO of Volcube.
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Trading options at or near expiration can require a different approach to trading options that still have plenty of time left. With this in mind, many traders prefer to exit their position before expiration looms too large. Avoiding expiration can be done either by rolling a position into the next or a later expiration, say from March to June or October to November. This might be desirable when the trader effectively wants to maintain the current exposure for longer. An alternative avoidance strategy is to simply liquidate the position. Some traders will factor in the cost of such a liquidation when they enter into the initial portfolio. Others won’t. Either way, option traders should try to become au fait with some of the techniques of trading options at expiration in order to prepare for situations where the cost of exiting the strategy is prohibitive. Also, with the rise in popularity of very short-dated option listings, such as weekly options, opportunities may arise that certainly involve expiring options.
Trading options at expiration, it is important to understand what is happening intuitively. Options are ceasing to be options per se. Rather, they are on the cusp of vanishing into worthless nothingness or they are about to transform into the underlying itself (if they are physically settled. If cash settled, they are still about to turn into something of notable value). The point is that the ultimate destiny of any option is either to finish in-the-money or at/out-of-the-money and therefore without value. And the difference between these two is in one sense infinite! This explains why the option risks at expiration become explosively large. Contrast this with options that have a very long time before they expire; the day-to-day alteration in their value and Greek properties could be all but unnoticeable. Whereas options at the end of their life could see their value and properties changing by the minute.
A further implication of the very short term nature of expiration trading is that the output of standard pricing models (such as Black-Scholes) really need treating with caution. Such models are more the preserve of longer time spans when ‘averaging’ has time to take effect. But with only hours or a day or two until an option’s expiration, ‘average’ movement in the price of the underlying really has little meaning. As mentioned above, the outcome is becoming binary; rather than a range of outcomes being possible, it’s now a matter of either life or death for the option and and not much in between.
Here then is a useful technique for analysing the risk of an options portfolio nearing the end of its life. The idea is to perform a break-even analysis of the portfolio a day or so before the expiration occurs. This gives the trader a good idea of the outcomes he is exposed to and can help him in forming a judgement about whether a) he likes the risk/reward profile and b) whether ‘cutting’, ie liquidating, the position in part or in full is desirable. In this series we will considered a delta-hedged portfolio, but the same reasoning applies whether or not the portfolio is currently delta-hedged or not. Let’s take a look at an example here in Part II…
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