This is a follow up to my follow up on QE’s excellent Options Claus post.
In this study I’ll show that the week leading up to options expiration has historically been bullish while the weeks before and after have been neutral to bearish. Note: this observation will be added to the State of the Market report.
When is options expiration day? Equity and index options expire after the close of trading on the third Friday of each month. The week leading up to options expiration then begins on the preceding Monday.
[logarithmically-scaled]
The graph above shows three hypothetical portfolios trading the S&P 500 from 1988 that are only invested on the week leading up to options expiration (red)Â or the weeks prior (blue)Â or after (green).
And for the number lovers:
As the graph shows, for the last 21 years, the week leading up to options expiration (red) has been consistently bullish and the weeks before and after bearish in terms of both returns and percentage positive.
Interestingly, this observation is not consistent across the entire year. The following table shows options expiration week returns broken down by month, with particularly bullish months highlighted in green. We’re talking small samples here folks (just 21 observations per month) so take the next results with a large grain of salt.
What makes this observation tick? I’m not confident that I have the answer and I’d like to hear some additional thoughts from readers [that means you Adam Warner].
Look for the addition to the State of the Market this week as an intermediate indicator. I’m not a huge fan of seasonality plays like this, so I’ll give it a low weight in the aggregate prediction, but it’s been such a consistent indicator (and so completely different from anything else on the report) that I think it makes an interesting addition.
Happy Trading,
ms
Â
To stay up to date with what’s happening at the MarketSci Blog, we recommend subscribing to our RSS Feed or Email Feed.
Filed under: Options-Expiration, Time-based | 9 Comments
Another killer post Mike – question for you: when you say week leading up to, are you assuming you buy the open or close on the Monday before options expiration? And sell when?
I think the answer is simple here. If the week leading up to expiration week is actually the 2nd week before expiration week then that would mean that week is the first week of the month. Based upon my studies the first week of the month on a historic basis has been bullish compared to the other weeks of the month. In my mind this doesn’t have anything to do with options expiration but rather that stocks tend to go up in the first few days of the month due to payroll deductions going to mutual funds, 401(k)s and pensions etc…
Eric W
perhaps market makers and hedge funds that sell large volumes of call options that don’t wish to risk major changes prior to expiration, yet do not have the liquidity to buy the options back . The obvious solution would be to buy the underlying stocks to hedge their risks. The counterargument would ask why the same activity does not occur with put options—which would neutralize the effect. Well, ostensibly many of the put sellers are large pension funds, retail investors, and to some extent mutual funds. Selling puts is an alternative to buying the stock, or a means of buying the stock at a price that they feel is desirable.They do not participate in call selling nearly as much because of the unlimited risk factor. Hence the bias prior to expiration week would rest with call sellers, who buy stocks on balance to hedge and drive the market up.
just a theory
RE to d and Eric: responding to both of you because I think my brief explanation in the post might have been a little to brief. I’ll use this month as an example. Options expire after the close this Friday (12/19). The week leading up to expiration would be from the close last Friday (12/12) to the close on this Friday (12/19). The week prior would be the close on 12/05 to 12/12.
So in Eric’s case, this is clearly not a result of early month returns. That’s a different observation (and one that I agree with you on).
michael
RE to david: sounds perfectly reasonable. I’ll mark that as the first potential explanation. Thanks! michael
Terrific post. Here is one theory:
Over long periods of time, the market exhibits a positive (some would say ‘inflationary’) expectancy.
Imagine large institutions holding put portfolios to continuously hedge their long exposure. As expiration looms and the odds of out of the money hedges expiring worthless increases (remembering the that historic positive drift), the manager is motivated to sell back the puts to recapture any remaining theta/time value of the options. In the aggregate, hedged counter parties are then off the hook and can progressively close their off setting short stock and futures positions, if any.
Now consider the call holder, again in an upward biased market. Naked sellers of in the money calls will most certainly have to buy the underlying to make good on delivery, but also may progressively buy even ahead of expiry to hedge their risk.
Any positive fuel the two effects add may even be self-reinforcing as expiration nears.
So over the positive trending long run, the two tendencies may explain the results. However, I wonder if they where sliced according to bull, bear or neutral market periods, volatility and/or put-call ratio regimes, whether different effects would be observed.
I know this post is a little dated, but I just discovered your blog and have a simple explanation for the upward bias during opex week. It is in an option market makers interest to decrease the value of all options to the greatest extent possible during opex week. One way to accomplish this is to smack the VIX down and a good way to do that is to have a rising or at least steady market. There also might be a natural bias to move markets up that week to particuarly crush puts. There are usually more puts than calls open as a result of hedging, although that might be changing with the general explosion in options activity the past several months.