oney calls have a premium, as in the preceding prices,then market makers are expecting a buy program. If in-the-money putshave a premium, then market makers are looking for a sell program.On that Friday, the market traded lower almost all day. Then, later inthe day, as expiration approached, large buy imbalances were posted for“market on close” orders. These imbalances are released at 3:40 P.M. bythe NYSE in order to advertise the blocks of stocks to be traded; this willdraw in sellers (in theory) to help out the specialist in making a fair and reasonable market.As the close of trading approached, and then as the “market on close”buy programs hit the tape, the relevant prices were as follows:
Time(P.M.)
OEX
SPX
S&P MarchFutures
3:594:004:014:034:05Final
384.51384.68384.95385.47385.80385.82
410.81410.90411.04411.29411.42411.43
411.80412.25412.20411.90412.00412.15
Gain from 3:59 P.M.to final:1.31
0.62
0.35
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First, notice that OEX rose 1.31 after 4 P.M. on the buy programs—from384.81 to 385.82—while SPX only rose 0.62 over the same six-minutetime period. This confirms the fact we stated earlier: that OEX will rise fasterthan SPX when the buy programs enter the market. Also, notice that theS&P March futures only rose 0.35—from 411.80 to 412.15. This meansthat the premium was shrinking on the futures as the end of trading neared.The actual strategy would be unwound by exercising the Feb 380 calls,receiving 5.82 as the settlement price (OEX closed at 385.82), and buyingthe March futures back in the open market. The profits and losses would be(note: in 1992, S&P 500 futures were worth $500 per point):
Position
Buy Price
Sell Price
5 OEX Feb 380 calls1 March S&P futureTotal Gain
6.50412.00
5.82413.30
Net Gain($)–340+650______+310
Of course, commissions would have to be subtracted from this figure,but they shouldn’t be more than $100 or so. Therefore, a profit remains.The investment required would be the full cost of the OEX calls, $3,250,plus the futures margin, which is about $9,000.The final point that should be made here is that this profit was made,even though OEX declined on the day (OEX was 386.02 in the morning,when the position was established, but closed at 385.82). Almost certainly,a straight call purchase would have lost money; but the hedged strategymade money because it was only attempting to capture the differentialbetween OEX and SPX, and not necessarily to predict the direction of theoverall market on expiration Friday.
The idea behind this strategy is that the OEX will go up at theclose of trading on expiration day, as the “market on close” buyorders are executed. The S&P Cash Index will not increase as much,nor will the futures contract, since the buy programs have a smallereffect on the broader-based SPX. Since it is expected that the buyingwill be concentrated in the stocks that make up the OEX, this strategy is a reasonable way to approach the problem of expiration in ahedged manner. The recommended hedged strategy is not con-
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cerned with the eventual market direction other than to attempt topredict the relationship between OEX and SPX at the close oftrading.The strategy is only intended as a day trade; keeping it as shortterm as possible (less than one full trading day) will help keep lossessmall. The risk is that SPX outperforms OEX on expiration day. Thiscould happen if institutional sellers come into the market to meet thebuy orders of the arbs, or if the arbs roll their positions after you, asa strategist, have established your hedged strategy, or if you havemisjudged the arbs’ position.In any case, you, as strategist, are attempting a day trade. Youshould wait until the market opens and stabilizes on Friday, expiration day, before taking a position. Even then, you shouldn’t establishyour entire position; you might wait to see if better prices are available during the trading day. The extent of the buy programs, if any,should be known by about 4:05 P.M. Eastern time as the market onclose orders hit the tape. The futures trade until 4:15 P.M. The position can easily be removed: merely exercise your OEX calls and buyyour S&P futures back in the open market before 4:15 P.M. (Note:expiration day is the only day that you can wait until after the closeof trading to exercise your OEX calls.)There may be additional benefits as well. Sometimes, the premium shrinks in the S&P futures, giving the hedged position anadditional profit. Also, if the market were to suffer a severe drop onexpiration day, large profits could accrue since you have a limitedloss on your calls but are not limited on the potential downside profits from the short futures contract. This has happened twice inrecent years.Expiration day, October 1987, was a rather harrowing day for the market.The arbs had been short stocks and long futures coming into expirationweek. There had not been much opportunity to remove the positionsbecause the portfolio insurance practitioners pushed the futures to discountson Wednesday and Thursday of the week. So, coming into Friday, itseemed as if there were going to be arbitrage buy programs. A strategy oflong October in-the-money calls and short December S&P futures workedbeautifully as the market plunged 107 points that day and the futures closedat a 4-point discount as well!
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It is a much lesser known fact that the November 1991 expiration waseven worse for the market. Again, as Friday, November 15, opened fortrading, it was a fairly common assumption that the arbs were short stockand long calls. Thus, buy programs were expected on the close of trading.However, the market began to sell off in midafternoon, and the selling gathered momentum. Eventually the Dow closed down 110 points and finishedon the low of the day (OEX was off 16 points). Moreover, by the close oftrading, arbs had removed their positions, and there were actually sell programs on the close! Again the futures closed at a discount, so our hedgedexpiration strategy position profit was even greater than anticipated.
A risk of this strategy is that the S&P futures might gain a lot ofpremium near the close for some reason, forcing the strategist to buyback overpriced futures in order to close out his position. Finally, oneother point should be made about the hedged strategy. It can bemodified into an aggressive one if conditions are right. If the buyingon the close is particularly heavy, there is almost always a downwardopening to stock prices on the following Monday morning, as stocksreturn to levels near where they were trading before the artificial buying took place. That doesn’t always happen, but it has occurredmany times in the past. In that case, the aggressive strategist mightwant to keep (some of) his short S&P futures over the weekend withthe intention of covering them on Monday morning after the opening of trading. This is obviously not part of the hedged strategy, but itoften proves profitable. This aggressive addition to the strategy introduces extra risk into the position because some news item mightcome out that forces the market higher on Monday morning, expiration forces notwithstanding.The preceding discussions all assumed that the arbs were goingto be executing buy programs on the close of trading. However, thatis not always the case. Sometimes they have sell programs, in whichcase the hedged strategy would be to buy five OEX in-the-moneyputs and one S&P 500 futures contract as a hedge. This hedge issimilar in concept: the risk is limited by the two hedged positions;and in this case, a large market rally (which wouldn’t normally beexpected to occur if there are sell programs around) could result invery large profits.
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Speculation Early in Expiration WeekThere is sometimes arbitrage activity prior to expiration day itself.This has become more common in recent years, and the activity ispredominantly concentrated in OEX programs, since the OEXoptions can be exercised early. In fact, if this preexpiration activity islarge enough, it can have the effect of reducing expiration Friday toa total nonevent. That is, the arbs can actually remove their entireposition in the last days prior to expiration. Thus, even if you havedone your homework and were ready for expiration Friday, that maynot be enough. You may have to be prepared to trade on Wednesday or Thursday preceding expiration as well, or be left with notrades at all. First, let’s discuss this from an arbitrageur’s perspective,and then later we’ll see how interested outsiders, such as ourselves,could make money from the arbs’ actions.The examples in the preceding section showed how the arbitrageurs unwind their positions on expiration Friday. However, thephenomenon revolving around the surge in prices on a Wednesdayor Thursday preceding expiration Friday is less well known. Sometimes arbs will attempt to unwind their position early because,although they are not guaranteed a perfect closeout of their positionas they would be on expiration Friday, they can often make moremoney this way. Once again, they unwind their position at or nearthe close of trading; but in this discussion, they are unwinding a dayor two early. The early unwinding relies on the fact that OEX optionscan be exercised prior to expiration day (they are American-style).Let’s assume that the arbs are short stock, hedged by the longcall/short put option position. We know that an arbitrageur canunwind his position at exactly parity on expiration day by buying allhis stocks back with market on close orders and also exercising hislong, in-the-money calls (or allowing himself to be assigned on hisshort, in-the-money puts). In either case, he unwinds the positionwithout risk. However, what if he could remove the position at adiscount to parity? Then he could make even more money. In orderto unwind at a discount, however, he would have to buy his stocksback before the market closed and then exercise his calls after themarket closed. If he had bought those stocks back at a lower price
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than the actual market close, this would in effect result in his removing his position at a discount to parity.Example: Suppose an arbitrageur is short all the component stocks of theOEX in the proper proportion and has them hedged by long, in-the-moneyOEX calls. Furthermore, suppose that he wants to attempt to remove thisposition at a discount to parity. At about 3:45 P.M. on the day before expiration, he begins to buy some of his stock back in the open market. Thisforces OEX a little higher, so he buys more stock back. Again, OEX isforced higher by his buying actions. Finally, he buys the remainder of hisstock back, market on close, and exercises his calls. The following figuresmight be representative of the prices he received.Time of Day (P.M.)
OEX Price
Action
3:45
525.00
3:50
525.50
4:00
526.00
Buy back one-quarter of shortstock positionBuy back another quarter ofpositionBuy back the remainder marketon close and exercise thelong calls
Thus, the arb has bought back one-quarter of his short stock position at525.00, one-quarter at 525.50, and the balance at 526.00. His net OEXbuyback price is 525.62. Meanwhile, he exercises his calls, all at parity withthe close—526.00. Thus, he has removed his position at a 0.38-point discount to parity. If his position were large enough, that could represent a lotof money.
Arbitrageurs are, by nature, rather risk-averse people; arbitrageurs like to make a little, mostly risk-free money on each tradeand do a lot of trades. However, the arbitrageur assumes a certainamount of risk by attempting this early unwinding of his position; soyou won’t see all the arbs trying this. His major risk in the earlyunwinding strategy is that someone else— a natural seller, perhaps—will enter the market and force OEX to go down while thearb is in the midst of unwinding his position. If that happens, thearb may end up removing his position at a premium to parity, an act
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that could cost him a good deal of money. Still, there are more andmore arbs who will attempt this early unwinding if conditions areright. We’ll define what that means shortly.But first, there is one additional way that the arbitrageur canmake money by an early unwinding, but it involves even more risk:he can wait until the following morning to cover some of his shortstock. It should be understood what happens when a large OEX inthe-money option position is exercised: it often removes one side ofanother trader’s hedged position. An example of this was given inChapter 1, under “Cash Option Exercise.” Essentially, what happensis that some other trader (not the arb) has a spread in OEX in-themoney options, where one side is completely hedging the other.Then a call assignment removes the short side of this trader’s spread,and he is left with a long position. Since he had no market exposurebefore the assignment and now has great market exposure after theassignment, it is reasonable to assume that this trader will try to sellsomething in order to reduce his exposure.Thus, an early assignment of OEX calls produces selling pressureon the market the next morning; similarly, an early assignment ofOEX puts produces buying pressure on the market the next morning.Consequently, an arbitrageur who was short stock and also exercisedhis calls on, say, Thursday night might wait until Friday morning tocover some of his short stock because he knows that it is likely thathis large call exercise will force the market lower on Friday morning.Of course, the arb assumes additional risk by attempting to do this,for there could be some news items that come out overnight andmake the market rally, which would force him to cover his shortstock at higher prices.In summary, then, the arbitrageur can remove his position in oneof two ways:1. The riskless way: on expiration Friday, buy stocks back withmarket on close orders and exercise his calls for cash.2. The aggressive way: on Wednesday or Thursday precedingexpiration day, buy stocks back aggressively during the lasthalf hour of trading; exercise calls for cash after the close;and possibly cover some remaining short stock the followingmorning.
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We mentioned earlier that the arbs will only attempt the secondway—the aggressive early unwinding—if conditions are right. Whatwe mean by that is that they won’t try to force the market in theopposite direction from which it is naturally trending. Thus, if theywere contemplating an early unwinding on Thursday’s close, but lateon Thursday afternoon the market was selling off sharply, they wouldnot attempt to jump in the way with their buy programs. In that case,they would most likely just unwind their positions on Friday, via theriskless way. On the other hand, if the market were already rallyingon Thursday afternoon, they might feel more certain that they could“pour fuel on the fire” and get a really big rally going by buying backtheir short stock as part of an early unwinding.
The September 1994 expiration saw one of the biggest market moves dueto early unwinding. As expiration week approached, open interest was oneof the largest ever. A persistent rally since late June had allowed arbitrageurs to establish large hedged positions of short stock and longcalls/short puts. Moreover, that same rally had now placed almost all ofthose calls in-the-money, so the potential was great for arbitrage activitynear the September expiration.On Monday, Tuesday, and Wednesday of expiration week, OEX closedhigher each day, although only by a point or two. OEX closed at 435.22that Wednesday. Then, as Thursday’s trading unfolded, another modestrally was under way. By Thursday afternoon, the rally had gathered a littlesteam, and OEX was trading near 437 shortly after 3 P.M. At that point, therally began to gather more steam, and OEX was up to nearly 439 by 3:50P.M. Then, a huge buying spree hit the market late in the day, driving OEXall the way up to 442.03 on the close. So, OEX closed up 6.81, and theDow Jones Industrials were up 58 points.The arbs had had a field day, jumping on an already rising market andpushing it higher quickly. But the arbs weren’t done yet: on Thursday night,they exercised all of their in-the-money calls. It was the largest call exerciseever in OEX (up to that date). All OEX in-the-money calls—even the September 440 calls, which were only slightly in-the-money— closed at parity,as market makers knew that the exercises were forthcoming (by the way,those Sep 440 calls rose from one-quarter on Wednesday’s close to a priceof 2 on Thursday’s close). Those call exercises represented over $6 billionworth of OEX stock; thus, $6 billion of stock had been bought by arbs onThursday afternoon.
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The next morning (Friday), the market opened down substantially (OEXwas off nearly three points in early trading), partly due to a reaction to theearly exercise and partly due to bond market jitters. Thus, arbs who hadheld any short stock overnight were able to cover it at better prices on Friday morning. Needless to say, there was no buy program on Friday: OEXclosed down 3.82 on Friday. The close of trading on Friday was very dull.
Thus, September 1994 was perhaps the ultimate real-life example of how early unwinding takes place and how it can affect the market. In fact, the overall stock market declined for several weeks afterthat, with OEX reaching a low of 418 on October 6. This is not toimply that the expiration activity caused the market to decline for several weeks, but it does demonstrate that expiration week can moveentirely differently from the natural tendency of the stock market.For those who understood the strategy, the events of that Thursday, September 15, 1994, seemed rather logical. But it was soonapparent how many people didn’t really understand what had happened. The aftermath of that expiration produced some almost comical comments by the media. After Friday’s down day, CNBCtelevision reported that expiration was a “sell,” and they figured themarket should rebound on Monday morning as an opposite reactionto the expiration sell programs. Apparently, since Friday was expiration and a down day, the television commentators figured that therehad been sell programs (they seemed to have totally missed the buyprograms on Thursday). In fact, there had been almost no expirationrelated programs at all, and the market traded lower on Monday also.Barron’s ran numerous articles trying to explain what had happened; and in those you could almost feel that certain arbitrage firmswere feeding somewhat nonsensical information to the media, perhaps in an attempt to keep everyone from understanding what reallytook place. The gist of the Barron’s summary was that OEX tradersand arbs bought OEX calls, then went in and bought OEX stocks inorder to increase the price of their calls, and then exercised their callson the close. If that was true, how were these “OEX traders” supposed to have disposed of their long stock—at big losses on Friday?Nonsense, to be sure; but when it was printed in Barron’s, a lot ofpeople believed it. Not all public commentators were unaware ofwhat had happened, of course. After the market was down 67 on
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Tuesday following expiration, Larry Wachtel of Prudential acknowledged that the market needed to work off the artificial buy programof the preceding week. So at least he got it right.The arbs were able to make such a large impact that Septemberbecause “conditions were right”: the market was trading higher, andthere was ample knowledge that a large arbitration position existed.However, when conditions are not right, the arbs will stand aside.You might want to go back and look at the example of the May1995 expiration, which was described earlier in this chapter. Thattime, a Fed governor’s negative comments generated true sellers ofstocks, and the arbs conveniently stepped aside late in the day, preferring not to fight the trend. Conditions were not right for the arbsin that case.
Trading with the ArbsSo now that we have spent all this time explaining what the arbs aredoing, let’s see how the individual trader or interested outsider canmake some money from this knowledge. Again, you have two approaches: (1) you can buy calls and attempt to speculate on what thearbs will do, or (2) you can take a more hedged position, figuring thatyou might not make as much, but it won’t hurt as bad if you’rewrong, either.If you are going to merely buy calls—a strategy that has beenhighly profitable whenever the arbs do indeed make their earlymove—I would recommend approaching it in this manner: try tothink like the arbs do, for they will do their buying late in the day andthey won’t fight a declining market. So, you, too, should wait untilfairly late in the trading day before buying in- or at-the-money OEXcalls, but only if the market is up on the day or has risen significantly from a much lower low.If those conditions are met, then buy your calls; but you mustsell them (or exercise them) at 4 P.M. that same day, for you don’twant to get stuck with them overnight. If the arbs exercise a massivequantity of OEX calls, that could force the market lower the nextmorning; and that would harm your long call position. So, inessence, you approach this like a very short-term day trade: buy your
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calls at 3 P.M. or 3:30 P.M. and get out at 4 P.M. As you can see fromthe example of September 1994 expiration, the market can move agreat deal in the last hour or half hour if the arbs are “operating.”A hedged position can also be taken, much like the one that waspreviously described for trading on expiration day itself. With thehedged position, you would once again buy five OEX in-the-money,short-term calls and hedge them by selling an S&P 500 futurescontract.If you are implementing this hedged strategy on Wednesday orThursday before expiration, you should be careful not to use theS&P futures contract that expires on that Friday. Rather, you shoulduse the “front-month” contract, which is the term that describes theactive contract. For example, if it is currently September, one wouldbuy OEX September calls and sell the December futures contract.Experienced futures traders know that the fastest and best executionsare only available in the “front-month” contract. As before, thishedged strategy should be removed at the close of trading.However, there is another small difference between using eitherstrategy on a Wednesday or a Thursday rather than on expirationFriday itself. That difference involves exercising the OEX calls. Recallthat on expiration Friday, you can merely call your broker after theclose and exercise the calls (or they will be automatically exercised foryou if they are in-the-money). However, the same courtesies do notapply to early exercise of OEX calls. On a regular trading day, whichwould include the Wednesday and Thursday before expiration Friday, you must have your OEX exercise instructions in by 4 P.M. Sowhile you may certainly have a good idea in advance of 4 P.M. (say,at 3:45 P.M. or so), whether or not you will exercise your calls, youmight prefer to actually trade out of the calls after 4 P.M. rather thanbother with the exercise.
The Postexpiration Effect of Futures onthe Stock Market: A Trading SystemEarlier, there were allusions to the fact that in the week followingexpiration, the stock market often has an opposite reaction to thebuy and sell programs of expiration week. In general, this is true; but
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as with all general statements of this kind, you must be careful if youintend to use them as a basis for trading.Using OEX as the measure of market performance, we did somespecific historical analyses of what happens to the market in theweek following expiration. The results are quite interesting and haveproven to be tradeable in the past.In order to conduct this study, we needed to determine whetherthere were buy or sell programs during expiration week and if therewas an opposite move during the week following expiration. First,we determined the largest absolute move that occurred the weekprior to expiration by observing the move from the second Friday ofthe month either to the highest closing price of Wednesday, Thursday, or Friday of expiration week or to the lowest closing price ofthose three days. This gives us the information as to whether buy orsell programs occurred during the week prior to expiration.Then, we looked at the resulting moves from expiration Friday’sclosing price to the minimum (maximum) closing price during the following week. So, if the market was up during the week prior to expiration, we looked for the lowest closing price of the following weekto see if the market had a reverse reaction to the buy programs. Conversely, if the market was down during expiration week, we lookedfor the maximum close during the week following.The data in Table 3.1 summarize the study (months in whichthere was no significant move prior to expiration were ignored).From this data, it can be seen that the market does, indeed, oftenhave an opposite reaction to the movements of expiration week.Some traders seem to feel that this effect is more pronounced at thequarterly expirations, when S&P futures expire on the same day asOEX options. Thus, we have broken the data out for those quarterlyexpirations as well. In either case, the market appears to reverseabout 80 percent of the time, or four months out of five.The pertinent question, of course, is “Is there a system that canbe devised to trade this phenomenon?” In order to answer that question, we ran several sets of data, with different entry points and different (or even no) stop levels. The first conclusion that we came towas that you need to use a stop of some sort. There were severalexpirations in which the market continued on in the same directionafter expiration as it had been going prior to expiration. These are
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Table 3.1SUMMARY OF THE STUDY OFFUTURES’ POSTEXPIRATION EFFECTON THE STOCK MARKETTime Period
Number ofExpirations
Number of TimesMarket Reversed
Monthly ExpirationsAll expirationsAfter 1/1/85After 1/1/90
14212061
115 (81%)97 (81%)47 (77%)
Quarterly ExpirationsAll quarterlyAfter 1/1/85After 1/1/90
504222
40 (80%)34 (81%)16 (73%)
losses, and some of them were quite large without using stops (interestingly, many of these came in December, a month that you mightwant to avoid if you are trading this system).Surprisingly, it turns out that using an absolute stop is far superior to using a trailing stop. A trailing stop is one that you adjust tolock in profits as a trade moves in your favor.Example: Suppose that you buy the S&P 500 futures at a price of 563.00and want to use a trailing stop of 1.50 points. Initially, your stop would be561.50. However, suppose that the trade moves in your favor and thefutures close at the following prices over the next few days following inception of the trade. The new trailing stop is shown for each day, as it would berecalculated after the close of trading.S&P Futures Close
Trailing Stop
Comment
(1) 564.20(2) 566.10(3) 565.50(4) 568.00(5) 566.00
562.70564.60564.60566.50
Market up, raise stopMarket up, raise stopMarket down, same stopMarket up, raise stopStopped out
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THE VERSATILE OPTIONTable 3.2STOP = 2.20 OEX POINTSTime Period
Number ofTrades
Number ofProfits
TotalProfit
AverageProfit
Monthly ExpirationsAll expirationsAfter 1/1/85After 1/1/90
13311559
61 (46%)48 (42%)25 (42%)
139.08111.0287.71
1.050.971.49
Quarterly ExpirationsAll quarterlyAfter 1/1/85After 1/1/90
484022
25 (52%)19 (48%)12 (55%)
88.0974.4866.24
1.841.863.01
Note that on day three, when the futures closed lower at 565.50, butnot low enough to stop out the trade, the trailing stop was not lowered. Itcan only be raised, never lowered.
In our OEX trading system, we ran several scenarios, but thesetwo seem to be representative: using a stop of 2.20 OEX points, orusing a stop of 3.10 OEX points. In Tables 3.2 and 3.3, we break
Table 3.3STOP = 3.10 OEX POINTSTime Period
Number ofTrades
Number ofProfits
TotalProfit
AverageProfit
Monthly ExpirationsAll expirationsAfter 1/1/85After 1/1/90
13311559
69 (52%)56 (49%)30 (51%)
135.11108.1097.59
1.020.941.65
Quarterly ExpirationsAll quarterlyAfter 1/1/85After 1/1/90
484022
27 (56%)21 (53%)14 (64%)
84.7670.9271.25
1.771.773.24
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down the results by total number of trades, the number of profitabletrades, OEX profit per trade, and total OEX profit over the life of thesystem.The best average profit, in either table, is the more than 3-pointprofit per trade attained by trading the quarterly expirations since1990. However, all of the systems are reasonably good. Since 1990,the larger stop (3.10 OEX points) seems to work better, but that isprobably related to the fact that OEX has been trading at a higherprice in the 1