Trading Options at Expiration

Ratios where a certain number of options are purchased at one strike price and a larger number sold at
a more distant strike. For example, a call ratio spread consisting of 10 long $95 calls and 20 short $100
calls would be referred to as a 1:2 call ratio. Many of our discussions use a larger ratio—most typically
1:3. Each of these trades has a naked short component because more options are sold than bought.

The final hours of each expiration cycle are characterized by unusual market forces and price distortions
that, properly exploited, provide outstanding trading opportunities. These distortions are caused by the
breakdown of traditional option pricing calculations that depend on volatility and time decay to fairly
represent risk. As a result, options are unavoidably mispriced during the final few days.

End-of-cycle price distortions represent a market inefficiency that cannot easily be exploited by large
institutions for reasons related to liquidity and execution efficiency.

This approach to trading offers three compelling advantages: a reduced risk/return profile, limited
market exposure, and extremely high returns on a percentage basis. In addition, the focus on price
distortions and market anomalies makes for a direction-neutral strategy that doesn’t rely on the
investor’s ability to “pick stocks.” We explore a variety of trades that typically return anywhere from
40% at the conservative ends to as much as 300% at the high end.

In point of fact, just a few days before these words were written—at the April 2008 expiration—the
exchange-traded fund OIH opened at $200 with the $200 straddle trading for approximately $2.50. By
12:00 the stock had climbed to $208, and the straddle was worth more than $8.00—a 220% profit.
Stated differently, every $10,000 invested grew to $32,000. This sort of behavior is the norm on
expiration day when stocks move from one strike to another and options are very inexpensive. More
important, an investor who purchased this straddle risked only a modest amount of steady time decay.
A typical expiration Friday presents several such opportunities.

In all cases, because we are actively trading these positions in real time with no intention of taking any
options home after the close, there is little risk of losing money. Discipline is the key, and, as always,
losing positions should be closed or adjusted.

Market Forces

End-of-cycle effects that are not comprehended by contemporary pricing models fall into three
categories

• Implied volatility collapse on the final trading day

• Strike price effects, including “pinning”

• Rapidly accelerating time decay