This week I would like to share the results of a 10-year back test of market action on the Monday following a Friday options’ expiration using the S&P 500 tracking stock (SPY) as the underlying. Interesting conclusions could be made regarding two popular trading maxims. Enjoy the report.
Terry
For many years, we have noticed that markets seem to trade lower on the Monday after an expiration. Others have noted that markets on that day tend to trade in the opposite direction that they did on Friday. This notion would support our belief that market professionals usually engage in some minor market manipulation on Friday to force many stock prices to a point very near a strike price so that their short options at that strike will expire nearly worthless.
If such market manipulation does take place, it would involve trading in the stock on Friday rather than options. If the stock needed a nudge to the upside to move it exactly to a strike price, these professionals would be buying the stock. They would be selling stock if they desired a lower stock price on Friday.
I either case, they would be expected to reverse those stock trades on Monday, moving the market in the opposite direction that it moved on Friday.
If we were confident that either of these observations could be relied on, there would be some major benefits to our option trading in at least two important ways:
1) The decision of whether to roll over out-of-the-money options on Friday or wait until Monday.
Up to this point, we have assumed that we have no idea which way the market will move on Monday. Since we know that if the market is the same on Monday as it was on expiration Friday, both put and call options will be about $.05 lower on Monday (there are two days of theoretical decay over the weekend). So we have considered it a toss-up between the two choices. Buying back out-of-the-money options on Friday will cost a little (although there is no commission at thinkorswim if the cost is $.05 or less) but you should be able to get about $.05 more for the next-month options when you sell on Friday rather than waiting until Monday.
Clearly, if we were confident of which way the market might move on Monday, we would not consider it to be a toss-up decision. If we believed the market would trade lower on Monday, we would buy back out-of-the-money calls on Friday and sell next-month calls, and we would let out-of-the-money puts expire worthless because we would expect better prices would be available on Monday. We would do the reverse if we believed the market would be higher on Monday.
2) The decision of whether to close out short iron condor spreads on Friday or let them expire worthless and wait until Monday to establish new positions.
We face the same decision with short iron condors as we do with expiring out-of-the-money options on expiration Friday. Assuming that we had a successful short iron condor in place and both expiring short puts and calls were out of the money, we could buy back those short options on Friday and establish new iron condors, or let them expire worthless on Friday and place new condors on Monday.
The same conclusion would apply here -- if we were confident of which way the market might move on Monday, we would not consider it to be a toss-up decision. It is a little more complicated with short iron condors than it is with calendar spreads, however. In order to close out a short iron condor (and free up the maintenance requirement), you have to buy back both the expiring puts and calls.
But now comes the interesting possibility. If we believed there was an excellent chance that the market would trade lower on Monday, we could buy back both the short expiring puts and calls on Friday, and place the call side of the next-month short iron condor on Friday. If the market does indeed trade lower on Monday, the put side of the short iron condor would command a higher price on Monday (while the call side would command a lower price, we would already have that side of the spread in place).
Of course, we would do just the opposite if we believed there was a good chance of a higher price on Monday, we would place the put side of the new short iron condor on Friday and wait until Monday to place the call side.
Legging into a short iron condor can be a little dangerous because if you are wrong, you would collect much less for the spread than you could have taken in by executing both the puts and calls at the same time.
It seemed like a good idea to check out the history of price changes on expiration Friday and the following Monday to see if we might gain a statistical edge in predicting what will happen on Monday in future months.
Here are the results over the past 10 years of expirations:
On Monday, SPY ended up lower than Friday’s close 57% of the time. However, another 14% of the time, the stock traded at least $.50 lower on Monday during the day but ended closing up. This means that if you waited until the stock was $.50 lower on Monday and made your trades, you would likely get better prices on the short puts you sold in 72% of the months.
The average change for the Monday following an expiration was -$.10. If you did not count the November 2008 change when the market was at its craziest, over the 10-year period, the stock fell by an average of $.29 on Monday.
The idea that the market traded in the opposite direction as it did on Friday was absolutely incorrect. Exactly 50% of the time, the stock traded in the same direction on Monday, and another 50% of the time, it traded in the opposite direction.
However, if you only bet on a lower market on Monday when the stock rose on Friday, your chance of success would rise slightly (to 75%) if you used the same $.50 rule as a guide as to when to sell. (Using this rule would result in more better prices on Monday but would miss out on the 36% of the time when the stock fell by at least 1% (about $.90) on that day.
In conclusion, betting on a lower market on Monday is a pretty good wager, but betting that the market will reverse Friday’s direction on Monday will not result in incremental gains.
Any questions? I would love to hear from you by email (terry@terrystips.com), or if you would like to talk to our guy Seth, give him a jingle at 800-803-4595 and either ask him your question(s) or give him your thoughts.
You can see every trade made in 7 actual option portfolios conducted at Terry’s Tips and learn all about the wonderful world of options by subscribing here. Why wait any longer to make this important investment in yourself?
I look forward to having you on board, and to prospering with you.
Terry
It was another tremendous week for the market. The S&P, Dow, NASDAQ, and Russell all gained 5.9%, 4.4%, 1.2%, and 5.1%, respectively. For now, it seems as though nothing can stop the advance as traders view news about banking and unemployment in a strictly positive light.
Bank stocks have helped to lift the S&P 500 an incredible 37.4% since early March, when the major market benchmark fell to a 12-year low. However, even with the hefty advance the index remains 40.6% below its October 2007 high.
"We trust the rally," said Chris Hyzy, chief investment officer at US Trust. He said the rapid climb since March 9 is justified because investors are no longer running from worries about a possible depression.
On paper, Wall Street has gained close to $2.9 trillion in value since the rally two month rally began. Much like the two month rally, bank stocks led the advance this past week as investors seemed relieved that 10 out of the 19 companies that underwent the so-called “stress tests” will only need to raise $75 billion in new capital.
"If anything, the market is reading this more as a sign of approval than a bad sign for the weaker banks," said Jim Sinegal, equity analyst at Morningstar.
The consensus among economists is the belief that challenges remain, but with that being said the market has demonstrated some resiliency as it has put in the best two month performance in almost 35 years.
"Every economic report, every earnings release is going to continue to paint a picture of an economy that is on the mend and that is going to form the foundation for this rally, which I think is sustainable," said Jack Ablin, chief investment officer at Harris Private Bank.
Other than the “stress tests” unemployment was the key economic report out this week. On Friday, Nonfarm Payrolls came in at -539,000 which was well below economists’ consensus of -600,000. However, this did not stop the unemployment rate from rising to 8.9%.
"The news is never all good when you've hit bottom," said Alan Skrainka, chief market strategist at Edward Jones. "But that doesn't change our view that the rate of decline is slowing." On the technical front, several of the major benchmarks are in a short-term overbought state which means that a 1-2 day decline should be anticipated.
One thing is certain, the market has held up extremely well in spite of the short-term negatives that have pushed into the market over the past few weeks. We have seen this type of short-term overbought state several times recently and each time we witnessed a pullback followed by another significant rally.
My focus is currently on the NASDAQ or NDX. It seems as though the 1410-1420 area is acting as a strong area of overhead resistance so a push above that level would certainly bode well for the intermediate-term future of the index and the market in general. A rally back towards 1410-1420 that cannot hold would suggest a much tougher ride for that index in the coming weeks.
Overbought/Oversold as of May 8, 2009