Does Options Expiration Week Equal Stock Market Strength?

(This is a follow up to my follow up on QE’s excellent Options Claus post.)

In this study I’ll show that the week leading up to options expiration has historically been bullish while the weeks before and after have been neutral to bearish. Note: this observation will be added to the State of the Market report.

When is options expiration day? Equity and index options expire after the close of trading on the third Friday of each month. The week leading up to options expiration then begins on the preceding Monday.

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[logarithmically-scaled]

The graph above shows three hypothetical portfolios trading the S&P 500 from 1988 that are only invested on the week leading up to options expiration (red) or the weeks prior (blue) or after (green).

And for the number lovers:

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As the graph shows, for the last 21 years, the week leading up to options expiration (red) has been consistently bullish and the weeks before and after bearish in terms of both returns and percentage positive.

Interestingly, this observation is not consistent across the entire year. The following table shows options expiration week returns broken down by month, with particularly bullish months highlighted in green. We’re talking small samples here folks (just 21 observations per month) so take the next results with a large grain of salt.

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What makes this observation tick? I’m not confident that I have the answer and I’d like to hear some additional thoughts from readers [that means you Adam Warner].

Look for the addition to the State of the Market this week as an intermediate indicator. I’m not a huge fan of seasonality plays like this, so I’ll give it a low weight in the aggregate prediction, but it’s been such a consistent indicator (and so completely different from anything else on the report) that I think it makes an interesting addition.

Comments

[David White:]

Good article. I am a little reassured that the market wants to go up. From the charts the SPY seems inclined to go up. the distance has been narrowing between the 20 day ema and the 50 day ema. The 20 day ema is still significantly below the 50 day ema, but it is noticeably edging closer. A cross would be very much a near term bulish sign. It is beginning to look like that may happen.

On the negative side the possible US car industry failure is still a huge worry. Failure to resolve this issue positively could have a huge negative impact on the economy and on the equities markets. Literally more that 1,000,000 jobs could be lost in one fell swoop. Then too you have to consider the CDS implications. If any of these companies fails (worse if more than one fails), it could start a huge downhill snowball of CDS redemptions. This could virtually kill the financial industry. This area clearly needs to be more effectively regulated. Also the loans to emerging economies are a threat to start a CDS snowball. These economies are virtually all dependent on exporting their goods. That part of their business has been hurt dramatically in the current recession. Further for obvious reasons these same countries are having a very difficult time getting further credit to see them through this time. Without it, they are in very dire straits indeed. This just means that the threat of a CDS snowball still looms large for the financial industry. I think JP Morgan was complaining about this the other day, when the CEO mentioned the Bear Stearns counter party risk problems they had acquired along with Bear Stearns. This makes me very unsure how long the current rally can last. I think a prudent strategy would be not to bet to heavily in any direction.

2008 Dec 18 09:09 AM

[David White:]

I should have mentioned that one of the things that has been driving the markets upward is the impending Obama stimiulus bill, which most recently has been guesstimated at $850B. This is thought to be due out in late January. It seems to be providing fuel for a possible January rally. That could be derailed by other major problems such as a car industry failure or failures.

Another issue is that they are currently negotiating with the UAW to decrease benefits, so the car companies can be more competitive. This really needs to happen. The UAW does not want to give up their status as "more highly compensated" though because they want to convince the foreign car companies workers (in the US foreign car factories) to join the union. The UAW just does not get that they are strangling Detroit. Theit membership has dwindled by virtually an order of magnitude over the last number of years because they are strangling Detroit. They need to wise up. They are not doing what is in the best interest of their workers by causing them to lose their jobs.

Further Detroit is especially not competitive in the small economy car market (i.e. the most fuel efficient vehicles). This has further been adding to the woes of the US economy by adding to the amount of oil importation (and car importation). Apparently Detroit is at a $2000+ per car competitive disadvantage vs. foreign car makers due to its higher worker benefits. The government will be unlikely to let this stand. It justifiably feels that competitiveness in this arena is in the long term interest of both the US economy, the viability of the Big3, and ability of the US to further reduce oil consumption and greenhouse gas emissions. I don't think the UAW gets just how important a point this is to the government. It really has nothing to do with asking workers to take the brunt of the burden. It is just common sense economics. The model the UAW has been using in recent years is clearly not working for Detroit, and it has clearly nto been working for the UAW if you go by their membership numbers. The real question is, "Is the UAW going to 'get it' in time to avert a major financial disaster? Or are they going to subbornly pursue a course that has been a disaster for the last ten years or more?"

2008 Dec 18 09:32 AM