Option Trading: Pricing and Volatility Strategies and Techniques

CHAPTER 12

Expiration Trading

There are some risks that are unique to expiration. The good news is that in addition to generating specific risks, expiration also leads to some new opportunities for making profitable trades.

Some traders mistakenly believe that the Black-Scholes-Merton (BSM) model “breaks down” around expiration. This isn’t true. The model can only “break” if it ever “worked.” Our point of view, that the model is a framework for organizing thoughts, still applies around expiration. However, it is more important than ever to understand the limitations of the assumptions underlying the model, as some of these assumptions are less applicable than usual.

PINNING

When the underlying settles at, or very close to, a strike at expiration it is said to have been pinned. This happens far more than we would expect if the price action were random and the strike prices were nothing special. For example, if strikes were $5 apart we would expect to be within 10 cents of a strike 0.2/5 = 0.04 of the time.

I conducted a study of the 30 stocks currently in the Dow Jones Industrial Index and the 100 stocks in the NASDAQ 100. I looked at the number of times the stock settled within fixed distances of a strike. This was done from January 2002 until June 2009 (the start date was chosen so that all of the stocks were priced in decimals). The results are summarized in Table 12.1.

TABLE 12.1 Pinning in American Stocks

Dow
Distance to Strike	10 cents	20 cents
% of Stocks	5.65	9.97
Expected ...