Market Measures

Expiration Risk

| Mar 2, 2015
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    Market Measures

    Expiration Risk

    Mar 2, 2015

    When looking to place a new trade, we will typically do so with as close to forty-five days until expiration. This allows us enough time for our assumptions to play out and gives us an excellent opportunity to manage a winning trade. Additionally, by closing a trade early, we are able to avoid the gamma risk that increases as expiration approaches.

    In order to highlight this risk, Tom Sosnoff and Tony Battista will look at the how the delta and gamma change as expiration approaches for at the money, in the money and out of the money options. As we know, during the last week of an expiration cycle, the delta of an option will approach 1 or 0. In the money options that will be assigned will begin to behave more like the underlying stock and thus have a higher delta (closer to 1). This causes an in the money option to trade very close to parity with the underlying. This means that all of the extrinsic value will be removed and the option will be entirely intrinsic value.

    Out of the money options, on the other hand, will expire worthless and will have little directional risk so their delta will be lower (closer to or at 0).

    Gamma risk primarily comes into play for at the money options. Since small movements in the underlying can cause an option to move from being out of the money to being in the money, the delta will change very quickly. Since gamma is the value that an options delta will change, gamma risk expands rapidly when there is not a lot of time remaining. This can cause huge swings in the value of your options, causing winning trades to turn into losers.

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