Stan Freifeld

Make Great Expiration Day Trades

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This article originally appeared on The Options Insider Web site.

While everyone looks forward to Fridays, options traders in particular get excited about the third Friday of each month -- that is, expiration Fridays -- as they provide some unique trading opportunities.

As an options trader, no doubt you've been told to close out your expiring positions a few days or weeks before they "come off the board." And with many plays, that is likely the safest and smartest bet. However, you might be missing out on some of the most exciting action and, more importantly, profits.

Don't Let Market-Makers Take Your Cash

If you're planning to enjoy a long weekend away from your computer, it's probably wise to close out of your expiring options positions in front of that fateful Friday, as you won't be able to relax when you leave your portfolio up to chance.

But for those months when you're stationed next to your trading screen, here are some tips for making the most of the last moments you have with your expiring options.

Expiration is the time of the month when market-makers make some "bonus" money. This bonus comes from public traders who do not know how to properly exit their positions and leave nickels, dimes or more for the market-makers.

Since I'm going to tell you how to avoid this little trap, you will have yet another advantage over other options traders.

And that advice is as simple as "sell the longs and buy back the shorts."

Even though many of them would have expired worthless, it's worth a few bucks to have peace of mind.

Keeping Your Cash, Part 1: Call Options

Let's assume that you own an XYZ Nov 45 Call and, just before expiration, that XYZ is trading at $49. The value of your call should be equal to parity, or $4. In actuality, the market for the call may be something like a $3.90 bid price, and an offer price of $4.10.

Now, let's digress for a moment and look at this situation through the eyes of the market maker. If he can buy the call for $3.90, he will immediately sell (if he has inventory) or short the stock at $49. Then at expiration, the call will be exercised, so the market maker will end up effectively paying $48.90 for the stock, via the $3.90 he paid for the call plus the $45 strike (or, exercise) price of the option.

Since he also sold the stock for $49, he is left with a flat or zero-stock position, and a 10-cent profit per share. Remember that the transaction costs for a market maker are minimal. So that's almost a $10 profit (10 cents x 100) for each option contract, with no risk.

Now, $10 may not sound like much, but believe me, with the volume of contracts being traded today (upward of 10 million, sometimes even nearing 20 million in a particularly busy session), that could be a very nice day's work!

OK, back to your situation. If you do nothing with your option, then it will be automatically exercised at expiration. And, when you wake up Monday morning, you will have 100 shares of XYZ stock in your account for each option contract you owned. Now you're subject to unwanted market risk -- not good.

The alternative is to do basically the same thing that the market maker would do. Near the close of the trading day, short the stock at the current market price and then let the call be automatically exercised (i.e., buying shares at the $45 strike price).

You will end up getting out at parity, having a flat stock position and not having any market risk over the weekend.