Options Expiration and other landmines

Posted by downtowntrader | 10/19/2006 08:59:00 AM | 3 comments »

Muuad posted a good question in the comments section that I thought deserved a post.

Here is the question:

Here is a question thats been popping in my mind lately, and seeing as you have mentioned it a few times... Are there certain dates that "the fundamentals" take over, or other events that create difficulty (e.g. Options Expirations), and technical traders would do best to stay out of the markets? For example, Earnings (in general or for specific companies currently traded), FOMC meetings, Economic data reports, Options Expirations, etc.

What recommendation would you make to technical based traders to keep on their "Economic Calendar" as days better spent away from the trading desk?



The short answer is, it all depends on what type of trader you are.

Let's tackle options expiration first. If you are a position or intermediate term trader, then there is not much you can do about trading options expiration. They key idea to take, is that prices will deviate on options expiration, as options related noise is amplified. While some is overt manipulation, most of it is natural, due to the fact that most option holders will get out of option positions rather then exercise them. This has a natural tendency to "pin" a stock to a specific price with a high open interest. It is my belief that a lot of institutions also program trade in order to protect certain positions with large exposure to them, via calls or puts written. So how do you navigate this period?
  • Daytrading is generally quite difficult because of how complicated some of the options ramifications can be.
  • I don't initiate swing positions in the couple of days leading to expiration beacuse of pinning and or counter moves the following week.
  • I check the max pain level for open positions. If you are unfamiliar with the Max pain theory it is better explained by this program written to calculate Maximum Pain.
  • I will hold positions that are doing well, as long as Max pain above is not in direct opposition with my position.

For my style of trading, earnings are a no no. It is too much of a risk to try and predict which way things will shake out. Sometimes you may be right on earnings, but management will kill you with guidance. Other times the street was looking for something different and the stock will move violently in the opposite direction. I am not a fundamental investor, and trying to estimate earnings is not my edge. As a swingtrader, I am using fairly tight stop levels in order to increase exposure. Subjecting these type of trades to earnings is like playing russian roulette. Eventually you will have a disastrous gap go against you.
Intermediate term or position traders are playing for longer moves with much wider stop levels, so earnings may or may not be acceptable risks. Again, this totally depends on what you are trying to accomplish with the trade.

As far as other events, it all depends. Fed days are usually pretty crazy intraday. The past few fed days have been fairly benign, but some of the last Bernanke days where nuts. I would say that daytrading is not recommended as the mornings are fairly muted, and the afternoon is littered with countermoves. I typically will hold off on entering swings that day and possibly the day before due to the potential for an over reaction. I typically try to stay aware of other reports such as oil inventories, but prefer to ignore them mostly.

The most important thing about Earnings and news reports is to not get caught in trying to figure out what the implications are for each report. Let the markets decide and pay attention to the reaction. It doesn't matter if you have it right or not, what matters is how the markets react.

Hopefully this helps.

DT

3 comments

  1. Muaad // 11:07 AM  

    DT,

    Definately clears up a lot, thanks for your prompt and concise answer. One thing I noticed about your response is that you are always careful to say that "it depends on one's strategy/methodology"... and I find that to be very true. Many other less knowledgeable "trading gurus" forget to stress this point.

    I really do appreciate your generous sharing of knowledge,

    Muaad

  2. downtowntrader // 11:31 AM  

    Muaad,
    That is the whole key to trading. A lot of traders get mixed up following generally very good advice from others, but then applying it totally wrong. People always ask what do you think of this or that, but it all depends on your methodology. It doesn't mean squat to a position trader, if a stock will pull back to a 20sma, but it menas the difference between a winner and a loser for me. As long as you can keep "your" methodology defined and stick to it, then you are miles ahead of the average trader.
    Good Luck and thanks for all the good questions and comments. By the way, you are asking the right types of questions on this and other blogs in an effort to advance your knowledge. I wish you the best of luck.


    DT

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