Some observations about trading near-expiration options on the ES

We are looking to buy options  — Calls, if we think the next substantial move is up, Puts, if we think the next substantial move is down — at a cheap price and sell them back later at a higher price.

The business model is “buy low, sell high.” The options are simply trading vehicles we are using to capture changes in the price of the underlying security — in this case the S&P500 e-mini futures, symbol ES — in ways that make trading easier and more profitable.

There are four main advantages to trading options compared with trading the futures directly:

• Less risk. The maximum amount at risk is the premium paid to buy the option; trading the futures directly — even with stops in place — exposes you to unlimited risk;
• Less capital required. The premium required to buy any of the options we are interested in is usually less than the day margin required to trade a single futures contract
• More flexible trading. We advise our members not to hold futures contracts overnight, because adverse price moves in the futures can can happen before you have time to react, and because overnight margins for futures are about 10 times the margin required for intraday trades. Options don’t have the same risks or costs, but still allow you to capture the profit from big overnight moves.
• Less work. Trading futures directly requires you to monitor the price action almost constantly. Options can be traded profitably using resting orders without watching the market; some traders can make money from options without a real-time data feed.

Remember: the options we use are strictly for trading. We are looking for options that will move with the ES, which means we are trading options within a day or two of expiration, when the “time premium” is lowest. But we do not want to hold anything to expiration except in cases where our options are deep in-the-money,

The trading environment: what we trade

The options we normally trade expire on Monday, Wednesday and Friday at the close of trading in the ES. (There are now daily options that expire every trading day).

We usually are looking to buy an option a day or two before it expires, and sell it when it hits our price target. If it doesn’t move in our direction we want to sell it back into the market while it still has enough residual value to recover some of the premium we paid to buy it in the first place.

When we buy a Wednesday-expiration option on Tuesday night or in the pre-market on Wednesday morning, we have to be thinking about what it will take to change the price of that option before the value disappears as the clock ticks down to expiration.

In practice, we want to be out of those trades by 12:00 – 1:00 pm EST on expiration day, unless the market is moving strongly in our favor.

Even if it is, we need to be cautious, because the options gain or lose value very quickly in the afternoon of expiration as the chart at the bottom of this page shows.

A large percentage of the options we trade will expire worthless within a few hours

Because most of the options we trade will expire worthless, the price behaviour changes dramatically as the afternoon moves toward expiration. The behaviour is different for options that are ITM compared with options OTM.

As the day moves toward expiration, the time premium of the option disappear, and only the intrinsic value is left.

• For options OTM, the price declines quickly in the afternoon (unless they look likely to become ITM before the close). Changes in the price of the underlying, even if they are moving in your favour, may not move the price of the option very much.

This is different from the way the option price moves in the overnight or the morning sessions. In general the longer the time left to expiration, the less sensitive the option price is to changes in the price of the underlying futures contract. But on the morning of expiration day or the day before — that is, when the option has a reasonable chance of being In-the-Money — the price of the option will move in direct correlation with the price of the underlying futures contract.

The time premium is squeezed out as we get closer to expiration. Close to expiration, the price of the option is affected only by the odds that it will become ITM before the end of the day. 

• For options ITM, especially those deep ITM, the price of the option matches changes in the price of the underlying fairly closely, as long as the option remains ITM.

If it appears there is a chance the underlying future contract will move away from the Strike, and the option will become OTM, the price of the option will drop very quickly on the afternoon of expiration day.

There is no prize for being ‘almost in the money’ or ‘at the money’

There is no value in being almost in the money at expiration. The option that is only a nickel away from being good at settlement has exactly the same value as one that is 100 points out. Zero.

Options that are only slightly ITM are worth something, but not that much. For options that are ITM option at expiration the price is the distance between the Strike price of the option and the Settlement price of the underlying futures contract.

Today (Feb. 23, 2022) the ES closed at about 4220 and the 4270 Put, the one we were trading, closed at about $50. The value of the 4220 Put, which was at-the-money, was about $1.

(Options on the ES are multiplied by $50 to arrive at the total premium. The option trading at $50 represents a total price of $2500 per contract. When we buy an option at $5 and sell it at $50, the net gain is $2250).

Managing your entry is as critical as managing your exit

Often options are very thinly traded, and there are big fluctuations in price as a result, as well as gaps in the price and wider bid/ask spreads.

Price changes happen fast. Look at the chart below. The price moved from $40+ to $5 (or a total premium of $2000 per option to $250) in less than 60 minutes on several occasions. Highly volatile.

(On these charts the Options are Puts. The price follows ES, but in the opposite direction).

There was a brief period in the afternoon of 2/23, when it looked like the market might stop its decline and move up, and the price of the Puts dropped quickly.

When market resumed its decline the Put options quickly reversed and increased in price into the close.

Success depends on both where you get in and where you get out.

You have to think about both when you buy an option.

On the trade shown below, the night before expiration was the best chance to enter, but the entry price could still range from $5 to $10. As late as 10:30 on the morning of expiration. it was still possible to buy this Put at the overnight low (but only for about 15 minutes).

One way to manage the entry would be to use limit orders, especially in overnight sessions. But be aware that with the volume as low as it is for options, your order may not get filled, even if the price is hit. 

For the exit limit orders would also work, but with the same caveat; if you try to get the top tick, you may not get filled. If the market is in your favour (i.e. if your option is deep in-the-money) that may not make much difference. But if it turns against you, you could find yourself holding a worthless option into expiration.

Option price chart

These general statements about option trading are a little easier to comprehend with a concrete example, in this case Nat’s call to buy the 4270 Put on the ES. At the time the call was made the ES was trading above 4340, and the Put was about 70 points out-of-the-money.

Here is the full chart of the trading in the 4270 Put on the ESH22, expiring on Weds, Feb. 23, 2022. The chart covers two days. Note that the time stamps are for CST — Chicago time.

Click chart to enlarge.

The Options

And here is the price chart for the underlying security, ESH22, on Feb. 23, 2022

Both charts cover two days, Feb, 22 and 23. Time lines don’t coincide exactly. Note the times when the big price moves occur. How could you trade them using options with an initial price of $5-$10, i.e. a risk of $250 – $500? What would induce you to get in? What would drive you to get out?