When Options Near Expiration: A View of 3 Apple Options
When Options Near Expiration: A View of 3 Apple Options
Option theory may work great ñ in theory, but sometimes it pays to take a look at how options actually behave in the open market.
Case in point, what really happens as an option nears its expiration date?
Adam Warner wrote a couple of articles on how a stock might get ìpinnedî to a strike price on expiration. One reason?
You probably know that option values decay over time on an exponential basis. The closer to expiration, the faster the decay, culminating on expiration day itself when the option finally settles at its intrinsic value. With little to no time value, positions become ìbinary.î Options either have value or they donít.
One way to view the value of an option is the probability of that it will have any intrinsic value at the end of expiration day. When thereís lots of time left, anything can happen. But when time is short, outcomes become more certain. When that happens, changes in the underlying stock or index get magnified in the price and characteristics of the options.
A view of 3 options on Apple
To see what I mean, letís focus on three individual option contracts on Apple (AAPL) as they traded over the past couple of months ñ the Apple (AAPL) 350 calls for February, March, and July 2011.
The purple line on the stock chart shows the 350 price level. All three call options rose and fell along with the stock, but at different rates. In percentage terms, those February options (which have now expired, of course) jumped around a lot more than the July options did ñ especially when the stock crossed through the 350 area.
One could say they had higher gamma, which is another way of saying that the delta of those options was subject to more rapid change.
Option greeks review: Delta, gamma, and theta
An optionís delta is simply a theoretical measurement of the rate at which an option gains or loses value when the underlying stock moves by $1. An option with a delta of 50 (actually 0.50, but I like to multiply it by 100 to represent one 100-share contract) should ñ in theory, of course ñ move by 50 cents per $1 move in the stock.
Why would the July 350 calls maintain a steadier delta than the others? Well, when time is short, options are more influenced by their actual intrinsic value ñ or potential intrinsic value to be more accurate.
Just a few days before expiration with Apple near 360, those February calls were far more influenced by the difference between the stock price and the strike price than other factors. Another way to look at it is that the time premium embedded in those options quickly vanished, providing a lot less of a cushion than those July options, which still have a few months to go until expiration.
The tendency for the delta of an option to change as the underlying stock changes is measured by the optionís gamma. Thatís sort of the ìdelta of the delta.î While the delta shows how much the option might change in value based on a move in the stock, the gamma is a theoretical measurement of how much the delta itself will change.
Options that are deep in the money or way out of the money have lower gamma because the delta of these options doesnít change very much if the stock moves by $1 even if their values change. The at-the-money options have the potential for more delta movement ñ especially near expiration.
In a way, gamma represents risk. If youíre long the option, it represents the risk that any unrealized gains you have will evaporate. If youíre short the option (although naked short call positions require level 5 options approval at Zecco Trading), it represents the risk that youíre going to suffer large losses quite quickly.
Theta is shown as a negative value because it represents time decay, which is good for those who sell options (not so good for those who are long). Thereís not much theta in the July options (check back in June though), but plenty in, say, the March options that are expiring soon.
Notice the inverse relationship between gamma and theta? In a sense it represents the trade-off between risk and reward. If youíre long an option that has months to expiration, you donít suffer a lot of time decay, but you donít get a lot of gamma ñ and its potential reward in terms of increasing delta ñ either.
As expiration day looms, risk and reward become less theoretical and a lot more real. All the unknowns become finally known, the greeks become incalculable, and option values converge to a binary state ñ either in-the-money or out-of-the-money at 4:01 pm on expiration Friday.
"About Zecco
View Zecco's post archive >
