Options Expiration (OPEX)

[00:00:00.07] - Speaker 1
In this lesson we talk about the option expiration or OPEX and its importance. Unlike shares, options have an expiry. The option contract therefore has a duration and after expiry it can no longer be exercised and has no value. Before the expiration. We can exercise a contract or close the contract and resell it on the market.

[00:00:19.11] - Speaker 1
There are two main types of option, American and European. The main difference is that American options allow us to exercise the option at any time even before the expiry. This typically does not happen, but they do offer this possibility. European options, on the other hand, can only be exercised on the day of expiration. We then have different types of options based on expirations.

[00:00:41.03] - Speaker 1
In the table below we can see the weekly, monthly and quarterly options. Weekly options are options contracts that expire every Friday. There are 52 maturities for this type of option each year. Weekly options expire at US market close which is 4pm New York time each Friday. Weekly options allow the trader to benefit from short term news or catalysts.

[00:01:00.07] - Speaker 1
They are typically less expensive than longer maturities due to time decay. Weekly options typically lose value very quickly. If the underlying moves in the opposite direction, it is difficult to recover the loss and this makes them more risky. Also, many weekly options have less liquidity and typically a wider bid US spread. They are available on stocks, ETFs and indices.

[00:01:20.25] - Speaker 1
This brings us to the monthly options. Monthly options expire on the third Friday of each month. This week is referred to as option expiration week or opex. If the third Friday of the month is a public holiday, then the option expires at the end of the day on Thursday. However, this happens in rare cases.

[00:01:38.12] - Speaker 1
OPEX week typically brings more volatility to the market. The closer we get to the expiry, the more there is the risk of the option contracts being assigned by the issuer. After expiry. Unassigned contracts or contracts that have not entered in the money expire worthless. Finally, we find the quarterly ones that expire on the last trading day of March, June, September and December.

[00:01:59.18] - Speaker 1
Here we can see the option expiration calendar that you can find on the CMU website directly. But how are options assigned and what happens when they expire? If we want to exercise the options at expiry, we need to know the difference between two types of settlement. First we have the physical settlement. Most option contracts use this type of settlement.

[00:02:18.19] - Speaker 1
For example, if we are long call option on a stock such as Tesla at maturity, I can decide to exercise the contract in physical settlement. At expiration of the option contract the actual underlying asset is exchanged between the buyer and the seller of the option. Physical settlement is commonly used in option contract where the underlying asset is deliverable such as individual stocks, commodities or bonds. If the option is exercised, the option holder or buyer pays the strike price to the option writer or seller and receives the underlying assets in return. In this example, I will receive 100 Tesla shares in my portfolio.

[00:02:53.00] - Speaker 1
We then have cash settlements. At expiration of the option contract, the settlement is made in cash instead of delivering the actual underlying asset. The cash settlement amount is determined based on the difference between the strike price of the option and the spot price of the underlying asset at expiration. Cash settlement is commonly used in option contract where the underlying asset is difficult to deliver physically, such as stock indices, futures contract or currencies. The option holder receives a cash payment if the option is in the money at expiration, which is calculated as the difference between the underlying asset price and the strike price multiplied by the quantity of shares for each option contract.

[00:03:28.13] - Speaker 1
If the option is out of the money, no cash payment is made and the option expires worthless. Let's take an example. We hold an option on SPX with a strike price of 3900. In this example, we hold 100 units of the index at the strike. If at expiry the price of the index is 3910, we will receive a settlement of $1,000 which is $10 per $100, which is the unit of underlying for the option contract.

[00:03:54.10] - Speaker 1
But why is OPEX so important? In our daily report we often talk about OPEX and its effect on prices. In this graph we see the OPEX effect on the SPX index. As we can see, after the option expiration there is an increase in price movements and volatility. These are classic rallies and post expiry technical moves.

[00:04:12.20] - Speaker 1
This is why it's so important to read the amount of Gamma and Delta that expires at the end of the OPEX week to position ourselves. But let's try to dig a little deeper on the mechanics of the option expiration. Because we all know that after the expiration, strange movements tend to happen. The chart shows you those strange technical moves after the opex. Those moves can be referred as Gamma moves.

[00:04:35.17] - Speaker 1
To understand this point, we need to go back to the concept of moneyness. Different manliness have different Greek movements associated to it. Specifically for the delta, if an option expires out of the money, there will be no directional move as the delta will be zero. This is different for in the money options they will behave as if you were long the underlying meaning that the delta for the in the money position is 100. But what does this all have to do with Gamma?

[00:05:00.11] - Speaker 1
You would question. As we will see in the course, the gamma of an option is the change of the delta relative to its price. That means that if the moneyness changes, then we can see a big market movement due to Gamma. If an option goes from out of the money to in the money, all of a sudden there is going to be a spike in gamma that will drive a movement in delta. To hedge that position, the market maker is going to have to enter the market and that drives liquidity and price action.

[00:05:25.01] - Speaker 1
Because of these gamma effects, the market can get pinned at specific strikes based on current positioning. As a trader, you can take advantage of option expirations by either buying or selling options. Option buying strategies make money if the underlying stock sees a faster movement than what the options are pricing in. The profit comes from the delta and the directional exposure. In this case, you are long gamma and that means that you can make money from directional moves.

[00:05:49.13] - Speaker 1
Basically, if the market pins at a specific strike, you can make a lot of money. Our models can help you identify those potential pinning strikes. Option selling strategies, on the other hand, attempt to make money if the stock doesn't move that much. Since you are selling options, you want to buy them back at a lower price. And since option premium decays very fast into opex, the majority of your profits come from theta decay.

[00:06:12.05] - Speaker 1
We make money thanks to the theta effect. During the course, we will go into further detail about moneyness and the different strategies with options. We will also show you how to read and use our models.