Expiry of Futures & Options contracts has always been an event to look out for. Expiry day always brings a bit of extra volatility because traders are also moving their trades into next expiry. This makes it interesting because remember more volatility means more opportunity to trade.
But, for now we are not going to focus on that volatility. Instead, we will look at options premiums and its one of the most important characteristics. The very characteristic of Option premium that explains us two things
1. Option premiums reduce with time (assuming the price remains the same)
2. On expiry day, premiums reduce the fastest with passage of time
Now, how do we benefit from this?
We will address this question in 2 parts, what do we trade to benefit from this & how we trade it.
What do we trade?
The answer is fairly simple. We need to trade options. However, here the biggest dilemma is there are 100s of options to choose from which one/s to choose. Let us define this one by one with reasons.
Option Type: Ideally, we should select both Call and Put instead of just one option because losses arising out of one would be compensated by the other. However, this compensation does not cover our losses if there is a big move. (Remember Option Selling can have a lot bigger loss vs the Profit which is the premium received).
Strike: Strike price of the both the options should be nearest to the current market price (Sell 100 Call & 100 Put if the underlying is trading at 101). The reason behind this is that we are trying to capture reduction in premium due to passage of time.
Strikes closest to the current market price hold the largest value that can reduce with passage of time when compared to all other strikes.
This is true for both Call and Put.
Expiry: The expiry is an easy guess it is the current expiry date which is today’s date.
Now we know what to trade, let us see how to trade?
Time of Trade: Since we will profit from passage of time. We need the maximum time remaining to the end of day. So, we will take this trade at the beginning of the day.
Type of Trade: Selected options (both Call & Put) of strike closest to current market price could now be sold.
Protection: This is most important. Selling both Call and Put may save us from smaller movements but if a big move comes our losses could be much bigger than the maximum Profit we can make (Total Premium Received).
Hence, we should be buying protection. Protection can be bought by buying a Higher Strike Call and Lower Strike Put
In our case,
Sell 100 Call + Sell 100 Put
Protection: Buy 105 Call & Buy 95 Put
This will impact the profits. Higher Call and Lower Put will always be lower in premium than the 100 Call & Put. Now the Maximum Profit will be Net Premium Received (Premium Received – Paid).
However, with the protection in place our Maximum Loss will be limited to 5 (difference between 100 & 105/ 100 & 95) minus Net Premium Received.
Last few years history holds it that, we are more likely to make money in this trade if we do it with discipline and protection. Reason is simple. Premium Reduction with Time will happen without fail on every Expiry Day. However, big move in Option Premium due to big move in underlying may not come in all expiries.
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