Options Expiration Trading Strategy For Stocks (Trading Rules)

The $3.5 billion “secret”: how a bias skews S&P 500 option payoffs every month! In this blog post, we tell you how retail and prop traders make money on the options expiration day (OPEX).

For investors and traders in the S&P 500 index, the third Friday of every month holds a peculiar secret. This day, known as option expiration day, is consistently associated with an unusual and costly price anomaly that transfers billions of dollars annually between investors. You, as a retail trader, can participate in this.

A new study called The Derivative Payoff Bias (Guido Baltussen, Julian Terstegge, and Paul Whelan) documents an economically significant bias in the settlement prices of U.S. equity index derivatives, driven by complex hedging activities. Let’s refer to this as an options expiration trading strategy for stocks.

The strategy is based on evidence that the stock market tends to spike up at the open on the third Friday of the month (when equity options expire).

Related reading: –What is the options expiration day?

What is the “Third Friday Price Spike”?

A large portion of global index derivative trading activity centers on products tied to the S&P 500 index (SPX). Many of these derivatives, like certain futures and options, are “a.m.-settled,” meaning their final payoff price is determined by the index’s opening price on the third Friday of the month, known as the Special Opening Quotation (SOQ).

Researchers found that since the early 2000s, when 24-hour overnight trading became active, these settlement prices have been consistently biased upwards.

Here is the specific price pattern, which the authors call the Third Friday Price Spike (3FPS):

1. Drift Up: S&P 500 equity prices drift steadily upward from the close of regular trading on Thursday to the open on the 3rd Friday morning (9:30 AM E.T.). On these specific days, the SOQ exceeds the previous closing price by an average of 18 basis points (0.18%).

2. Sharp Reversal: Immediately after the derivative payoffs are calculated at the open, the price rise reverses sharply, falling back down by about noon the same day. This creates a distinctive “tent-shaped reversal pattern”.

This price spike (3FPS) is highly predictable, occurs nearly every year since 2003, and is not a general feature of index settlement procedures, as it is confined specifically to the a.m. settlement window. It is also documented in other major indices that use a.m. settlements, such as the Nasdaq 100 and the Dow Jones Industrial Average.

Who Wins and Who Loses? The $3.5 Billion Wealth Transfer

The Third Friday Price Spike has major economic consequences because it artificially inflates the price at which a significant volume of options settle.

When the SOQ is biased upward due to the 3FPS, it impacts payoffs in predictable ways:

• Call Options (Bets on price increases): Payoffs are biased upwards. Call option buyers receive a higher payoff, and some options that would have expired worthless (out-of-the-money) now expire profitably (in-the-money). This represents a wealth transfer from call option writers (sellers) to call option buyers.

• Put Options (Bets on price decreases): Payoffs are biased downwards. Put option payoffs are lower, and some options that would have expired profitably now expire worthless. This represents a wealth transfer from put option buyers to put option writers (sellers).

The estimated sum of these transfers in S&P 500 index options alone amounts to approximately $3.5 billion per year. This estimate represents a lower bound, as it excludes other SPX derivatives and other U.S. equity indices that also experience the 3FPS. The study also confirms that this price bias is not already “priced into” options by the 3rd Thursday close.

Options Expiration Trading Strategy For Stocks

What is the best way to trade this?

The biggest inefficiencies are in single-stock tickers, not the index. We have been trading this pattern and it has always been the most profitable day of the month (on average).

However, for retail traders, it’s not easy to trade it because you need to send a large number of limit orders to open only orders. This takes buying power and automation. Moreover, you never know how many fills or stocks you will end up with

For proprietary traders, it’s different. We traded opening only orders on the OPEX day for Echotrade (now closed) and Global Market Trading in Canada (still operational).

Here’s how we traded the order imbalance strategy at the open (trading rules):

• We first adjusted each stock’s closing price based on the movement of the S&P 500 futures. This gave us the fair value for the stock. For example, if futures pointed to a 0.5% higher open, we marked the stock’s fair value as 0.5% above the prior close.
• Next, we placed both buy and sell orders around this fair value. A buy order went in at x% below, and a short order at x% above. For instance, we might buy 0.5% below fair value and short 0.5% above it. Simple and mechanical.
• We sent thousands of these orders. At the open, some filled while many didn’t – on busy days, we could end up with positions in as many as 200 tickers.
• Exits were handled with a mix of profit targets and time-based exits.

These are the basic rules, but we also had a few additional twists.

Options Expiration Trading Strategy For Stocks – Why It Works (Logic)

We are not experts, and can’t say for sure why the spike happens. But the researchers investigated several common explanations for the price spike, including fundamental shocks (like earnings or macroeconomic news) and “pinning” (where prices cluster near option strike prices), but found no support for them.

Instead, the phenomenon is attributed to a “novel hedging channel” originating from the inventory management practices of option market makers (dealers).

The researchers pointed to key technical factors involved as “Charm” (C):

• What is Charm? Charm is a measure of how quickly an option’s delta (its sensitivity to price changes in the underlying index) changes purely due to the passage of time. Charm is most influential for options that are near expiration, meaning it becomes extremely important right before the 3rd Friday open.
• The Problem: Market makers typically hold short positions in index options and must maintain a “delta-neutral” position (meaning they hedge their risk by trading the underlying asset, like S&P 500 stocks or futures).
• The Chain of Events: Dealers often have a large negative net-Charm position when the market closes on the 3rd Thursday. Since Charm measures the drift in delta over time, a negative net-Charm implies that their hedge naturally drifts downward overnight. To prevent this, dealers are effectively forced to buy equities overnight to maintain their delta-neutral hedge.

Researchers estimate that dealers need to buy at least $280 million worth of equities overnight to maintain their hedge into expiry. This compulsory buying creates a huge order imbalance, which closely matches the $306 million abnormal overnight order imbalance observed, explaining the 18 basis point upward move (the 3FPS).

Implications for Regulators and Traders

This research suggests that because prices are predictable before the a.m. settlement, it opens up possibilities for predatory trading and market manipulation by sophisticated investors who are aware of the impending dealer hedging needs. The conditions needed to facilitate manipulation – differing price-order elasticities across markets, cash settlement, and a finite manipulation period – are all present during the illiquid overnight window before a.m. settlement.

The prevalence of Charm-driven hedging also has increasing relevance today, particularly with the surge in trading of zero-day-to-expiry (0DTE) options. Since Charm is most pronounced for options nearing expiration, this channel may become increasingly important in daily price dynamics.

Consequently, the authors argue that regulators should critically evaluate current settlement practices, especially those aligned closely with periods of illiquid trading, such as the a.m. settlement window on 3rd Fridays.