Last Updated on June 19, 2022 by Quantified Trading
The options expiration happens on the Friday before the 3rd Saturday each month in the US. An often referred to effect is the options expiration week effect. Is this effect for real or is it just a myth? In this article, we test the option expiration week effect:
The performance of the S&P 500 shows abnormal returns during the options expiration week. Only July and January show negative returns during the options expiration week, while April is the best month. Overall, there seems to be an options expiration week effect.
When do options expire? What is the option expiration week?
The options market is fragmented. There are options on futures, equity, or whatever asset there is. However, in this article, we only look at US stocks and equities.
US-listed stock options expire on the third Friday every month (to be precise: on the Friday before the 3rd Saturday each month). The only exception is when Friday is a public holiday (could be Good Friday or Independence Day). On these rare days, the expiry is on Thursday – the day before Friday.
What is triple witching options expiration week?
This happens when the options on stocks, stock index futures, and stock index options all expire on the same day. This happens four times per year: in March, June, September, and December.
Options expiration day creates imbalances
For those of us who day trade stocks and focuses on imbalances, the option expiration days (OPEX) are often lucrative. Both the open and the close have imbalances that can be preyed on.
The hypothesis is that “pin risk” causes a significant increase in trading activity, but more importantly to more imbalances and “abnormal” action (see more below).
What happens when an option expires?
In order to understand option expiration, we need to start by describing what options actually are.
A stock has theoretically an infinite life – at least until the company is either bankrupt, merged, or bought by some other company.
Opposite, options have a finite life: they expire and “cease working”. How is that possible?
For example, Microsoft might have call options with a strike of 120 with an expiry date of the 20th of October. The date today is the 1st of July and the price of Microsoft shares is trading at 110.
A call option means the owner of the option has the right to purchase shares in Microsoft for 120 either any time before the expiry date of 20th of October or on the expiry date (depending on the type of the option).
Thus, the time limit is set to the 20th of October. After that date, the option expires and literally ceases to exist. If the price of Microsoft is less than 120 at the expiry date, it doesn’t make sense to buy at 120. This means the option expires worthless. If the price is higher, the owner will exercise the option and buy at 120.
This means the price of the options varies significantly from how a share price is valued. The value of an option might be more influenced by the time to expiration and/or the volatility, and thus the movement can be substantially different from the underlying stock. However, it’s not the purpose of this article to into detail about options pricing.
How options expiration affects stock prices
The closer we get to options expiration (OPEX), the bigger the risk for delivery for the issuer.
Because of this, trading activity in options can have a direct and measurable effect on stock prices, especially on the last trading day before expiration.
Let’s briefly look at how “pin” risk can influence the overall market as well as specific equities:
Pin risk at options expirations
Pin risk involves the risk of having to take delivery of the shares if you have issued options. For example, if you have issued puts with a strike at 50, you are obligated to buy those shares if the share price is lower at expiration.
Many traders and investors don’t want to have the risk of being the owner of those shares over the weekend in case they get exercised. To offset this, they might sell the underlying shares. This way, the price of the shares goes up and down closer to expiry as traders take hedges.
Anyway, pin risk is a huge topic, but we hope you get a vague idea of the problems facing traders because of this risk and why the price might be more volatile on the expiration day.
The options expiration week effect trading strategy (OPEX week)
Based on the assumed positive effect options expiration has on stock returns we can backtest a simple trading strategy that buys on the open of the options expiration week and exits on the close of the options expiration day (normally a Friday). We own stocks during this week and stay in cash the rest of the time.
If Monday is a holiday, we enter on Tuesday. Likewise, if Friday is a holiday, we exit on Thursday.
We need to mention that the results vary depending on when and how we enter. For example, if we enter on Monday at the open or the prior Friday at the close give a different ranking of the best month. As always, traders need to do their own research if they want to use this effect/anomaly with real money.
Because most of the open interest in options is in the large-cap stocks, we test the effect on the S&P 500. We tested with both S&P 100 and S&P 500 but found only minimal differences.
We would like to emphasize that the options expiration week effect seems to work only from 1990 and later. Prior to 1990, we fail to see much effect. We can argue this is to be expected as it was only in the 1980s that derivatives really took off as trading vehicles.
The backtester code for trading the options expiration week effect
The effect is not the easiest to backtest – it’s a bit cumbersome to get the correct code.
However, if we plot the remaining days as a graph it looks like this in Amibroker:
The bottom pane shows the number of days to the third Friday of the week.
If you would like to have the Amibroker code for the options expiration week plus all the code for all the other free trading strategies we have published since 2012, please click on this link:
The results of the options expiration week effect
The equity chart below shows the compounding returns of being only invested in the S&P 500 during the options expiration week (from the open of the week to the close of the week – 100 000 compounded):
The CAGR is 3.4% and the average gain is 0.3% per week, higher than any other random week. Keep in mind that you are invested only around 10% of the time and the average number of bars in a trade is slightly less than 5.
For QQQ (Nasdaq) the number is 0.36% per trade.
If we enter at the close of the last trading day before the options expiration week, normally a Friday, the average gain increases to 0.35% per trade for the S&P 500. For QQQ and Nasdaq, it actually goes a little down because of poor performance in 2000/01.
Thus, we can conclude that there is an options expiration week effect.
Options expiration week effect per month
Does the result differ per month?
Yes, the result differs substantially per month. However, keep in mind that we only test from 1993 until May 2021 and only have 28 or 29 observations per month. Hence, “outliers” can distort the monthly results.
The result per month is as follows (100 000 compounded – see the last column for the average gain in %):
The equity curve (compounded results) for April looks like this:
Options expiration week strategy S&P 500
We frequently trade seasonal trading strategies and the options expiration week effect is a perfect example of such a strategy. Nevertheless, we believe you need to put in one more parameter to make it worthwhile for trading.
One example of an improved options expiration week effect strategy is our monthly trading edge for May 2022 for S&P 500. It’s an overnight strategy – from one day to the other. The equity curve looks like this:
If you are not a subscriber you can purchase single strategies or in bundles.
Quadruple witching day
Four times per year all financial contracts expire on the same day during options expiration day (stock index futures, stock index options, single stock options, and single stock futures). This happens in March, June, September, and December. These four days are called quadruple witching days and are always looked upon with great anticipation, especially by the media.
We have covered this day in a separate article that is called quadruple witching day and it contains plenty of backtests and facts.
International options expiration week
The US is not the only place where you have options expiration week, but it’s the only place where we have found reasonably good trading strategies based on this seasonal effect. We did a backtest of the main futures contracts in the EU, but we were not able to find any consistent edge as we can in the US.
We summarized our findings in five different articles:
- Trading the futures expiration week in DAX 40 and Euro Stoxx 50
- Trading the futures expiration week in Euro Bonds (FGBL)
- Trading the week after futures expiration in DAX 40
- Trading the week after futures expiration in Euro Stoxx 50
- Trading the week after futures expiration in Euro Bund
What happens after the option expiration week?
When you have read so far, you might wonder what happens the week after options expiration.
While we see a positive options expiration week effect, the effect fails to continue into the next week. The average gain for the week after options expiration is lower than any random week, but the results vary from month to month. There are three months that are particularly negative: February, June, and September. The latter is the worst – by far.
We covered the week after options expiration in a separate article:
The options expiration week – conclusion
Our backtest confirms that there is an options expiration week effect. However, it’s not tradeable on its own, in our opinion, and needs one or more parameters.