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Implied Volatility Collapse

The key ingredient on expiration Friday is volatility collapse. At the beginning of that last trading day, there are more than 6 hours of trading yet to go. However, there are 38 hours left before expiration on Saturday. When volatility is high, OTM options are most likely to be overpriced.

Because the public cannot trade options after Friday’s close, speculating on these positions must assume that price will move after last trading day but before Saturday expiration. Traders have no control over this, meaning it is taking a chance, whether going long or short.

With volatility collapse a factor in how price behaves on expiration Saturday, the question becomes whether it changes rapidly or smoothly – or not at all. Because it is unlikely that high volatility will be likely to decline smoothly, most traders will not want the exposure, especially when taking short positions. It may be reasonable if the price is low enough to speculate in a long call or put, hoping that volatility moves in a favorable direction.

Experienced traders will observe a predictable pattern in volatility collapse on last trading day, and this helps select a position that offers a better than average likelihood of profit. However, the profile is determined by volatility in the underling and will not be the same for all stocks. As with all option strategies, timing of last-minute trades based on volatility collapse must be done with familiarity of the underlying and its historical volatility. This assumes that implied volatility will closely follow that trend. It normally does, but given that expiration is about to occur, this is not always going to occur as expected.

If the analysis is limited at ATM options on last trading day, it should be kept in mind that these positions are overly sensitive to even the smallest change in the underlying price, notably in the final hours of trading. Because this takes place on Friday, even non-option stock traders behave with full awareness that they will not be able to trade for three days. This affects potential value of both the stock and its options. Implied volatility in this timing is going to be noisy in the sense it will be more volatile than usual. This may be an advantage or a disadvantage, based on many factors. Most option traders are fully aware of most of these factors.

Complicating matters even more, market behavior is not going to be rational in all cases, especially on expiration Friday (for option traders) and to a degree, on any Friday (for equity traders). This irrational behavior makes implied volatility noise even more intense than a trader might expect. A blind spot for many traders is the assumption that trading decision are made rationally, and this can lead to problems in timing.

Implied volatility must be expected to become increasingly unreliable and unpredictable for ITM options, and for many last-minute traders, ITM options are the preferred vehicle for trades. A related observation worth making is the reliability and stability of calls and puts in this moment. Because only one of the two will be ITM, it is likely that one side (ITM) will be unpredictable, while the other side (OTM) will be more predictable. This raises some interesting possibilities for last-minute spread trading, with emphasis on OTM positions as offering less risk, and ITM positions possibly presenting more profit (or loss).

Also affecting the potential profit or loss based on moneyness, is the pinning factor. If the underlying will move toward (or remain at) a price close to the strike of the closest option, how does this affect the timing of expiration trading? Pinning, like implied volatility, is not as predictable as traders would like, but it could be a factor. Some traders believe that option behavior can and does affect underlying prices. But this is only true in that very short-term time right near expiration, and not during the entire cycle. Trading on the assumption of how implied volatility will behave, tied into an assumption about price pinning, is a dangerous and often expensive strategy.

Most traders would not consider expiration trading as a form of equity hedging. However, it is possible to time option positions to protect equity profits (with covered calls, for example), representing a short-term hedge. For example, if the stock position is profitable, a covered call can be opened on last trading day ITM. If the underlying price moves above the strike, exercise produces a profit from both the equity investment and the option premium. If the underling price declines, the loss is reduced due to option premium, taking net basis down; and this further allows the trader to enter another covered call or similar position. Because expiration strategy does not allow traders to close or roll after Friday’s close, entering a similar hedge with a short put is not as wise. ITM expiration means unavoidable exercise, and most short put writers do not want exercise of the position. The short put strategy has the same market risk as a covered call, but at expiration, it is not as safe. A covered call is going to be advantageous whether underlying price rises or falls. This is not true with short puts.

In entering any option position, the assumed volatility collapse will occur in a predictable manner, but the speed and degree of movement toward zero is not the same in every case. This is where the interesting potential is found, either for profit or loss. Implied volatility for high-volume stocks will behave much differently for low-volatility issues. But even this does not mean the speed and degree of change is going to be predictable; it might, in fact, behave as irrationally as those traders in the market at this last step in the option’s lifespan.

Perhaps the most interesting selection for expiration trading is the case where earnings announcements are made after Friday’s close. In this case, public trading is no longer possible, but volatility could change significantly by the end of expiration Saturday. The trader’s dilemma in this case is that a big earnings surprise could be either positive or negative. Anyone speculating on this situation must be ready to accept a loss if the surprise is not a pleasant or desirable one.

Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his website at Thomsett Publishing as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.




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