Book Review: Trading Options at Expiration, by Jeff Augen

by: John M. Mason

This little book Trading Options at Expiration: Strategies and Models for Winning the Endgame, by Jeff Augen (FT Press, 2009) is tightly packed into 141 pages of highly technical analysis and explanation. It is Mr. Augen’s third book on options, the first two being “The Volatility Edge in Options Trading” and “The Option Trader Workbook.” They are all relatively dense books and are not easily accessible to the weekend reader who is anxious to learn how to make money trading options. “Trading Options at Expiration” is a good book for those who are serious options traders and want to explore other strategies with which he or she is not totally familiar.

The book is about “trading” and not about “investing”. It is about taking advantage of market inefficiencies to make money. To quote the author, “expiration trading focuses only on the underlying mathematics. It does not rely on any financial predictions, company results, or market direction.” It is not an easy thing to do:

“Trading subtle price distortions in the options market is a complex affair that requires an unusual blend of pricing knowledge and day trading skill. Expiration trading is a mathematical game distinctly different from stock picking.”

Since equity and index options expire on the third Friday of every month, expiration trading is concentrated at a specific time each month. In fact, expiration trading is concentrated in the final hours of each expiration cycle and is dominated by “unusual market forces and price distortions.” Why do these irregularities occur? Because there is a “breakdown of traditional option pricing calculations that depend on volatility and time decay to fairly represent risk,” Augen says. In other words, mispricing of an option can take place during the time leading up to the expiration of the option contract.

According to Augen, returns can be substantial: “Expiration trading provides enormous opportunities that scale with the amount of time and effort an investor is willing to spend.” But it is not easy. To follow the author's approach you have to have access to a huge and accurate database of stock and option prices. You must possess sufficient computer skills, and being able to program can be very beneficial. And you cannot consider this to be a part-time occupation; you must be a dedicated and disciplined practitioner of options trading. Augen has a professional background in computers and computer programming as well as experience in trading options.

After introducing his subject in the first chapter (there are only three chapters), Augen immediately gets into the data requirements of expiration trading. These requirements are rather significant and boil down to getting minute-by-minute data on a vast number of stocks and options. There are providers of such information. However, even though the amount of information needed is huge, adequate databases can be built and customized by many investors themselves “with little effort and no programming using the capabilities of Microsoft Excel.”

In chapter one, Mr. Augen explains the mechanics of “Expiration Pricing Dynamics” so that one understands how the price distortions he talks about can occur. With this information in hand, one can move to chapter two where the author describes how one works with statistical models to pick candidates and identify opportunities in which trading might take place. One must prepare for the expiration day by developing an understanding for each situation how the options pricing models perform as the time period before expiration collapses. In chapter three, Augen presents a variety of expiration-specific trading strategies. These strategies focus primarily on different time frames as an option moves toward the point at which it expires.

This book is a wonderful example of how market inefficiencies are identified and how strategies are then created to take advantage of the opportunities that have resulted from the inefficiencies. The author is blunt enough to state up front that his whole effort is related to “price distortions” that arise due to mathematical models of options pricing and how these models break down as the time of expiration approaches. There is nothing magical about this approach, nothing connected with value or management or investment. The effort is solely one of trading based upon market imperfections.

The downside of finding inefficiencies like these and then developing strategies to take advantage of the opportunities they present is that the process leads to the greater efficiency of the market and the reduction or elimination of the opportunity. Historically, we see this process taking place over and over again. The process is captured in the concept of “The Law of One Price,” or the “no arbitrage” condition where it is argued that the movement to take advantage of price distortions eliminates the price distortions.

This is why most traders do not want to divulge the types of transactions they are involved in. The people at Long Term Capital Management were adamant about keeping quiet concerning what they did because, they said, that if they provided information on what they did, everyone else would do it and the opportunities for gain would disappear. In most cases, many people do catch on to what these arbitragers are doing and they copy them, and the opportunities go away.

Of course, a corollary to this is that if everyone is in on the same transactions at the same time they will generally depart the transactions at the same time should the transactions not go well. This, of course, adds to the risk of engaging in such transactions.

One interesting comment I have seen on this book is that a reviewer of the book found it interesting that Mr. Augen provided the information he did and the strategies he has worked with. Since the strategies were apparently successful, the reviewer wondered why the author would release them because this would result in other people making money using the strategies but would bring an end to the price distortions upon which the strategies were based. Point well taken!

This is an interesting book, not only in terms of learning about an opportunity to make money in trading options, but also for the insight the author provides us into the process of finding such opportunities and inventing techniques to profit from them. This book describes how financial innovation takes place and helps us to understand why financial innovation will not be eliminated through any regulation that results from the passing financial storm.