I'd like to cover a topic I rarely see mentioned, and how it pertains to share price behavior I have noticed in SiriusXM (NASDAQ:SIRI) over the last several days before options expiration.
First, a quick explanation of options to bring some readers up to speed on what they are. You may find a lengthy explanation here if you have a bit of spare time. For this article, what matters are options which will expire "in the money."
An in the money option is an option which will not expire worthless. Currently, as of Friday's close at $2.35 for SiriusXM, all call options at prices $2 and below will expire in the money. All put options $2.50 and above will expire in the money.
What happens when these options expire? If you hold a $2 call option contract for SIRI the option would be exercised. You would pay out $200 for 100 shares of SIRI. Your SIRI shares you receive have a value of $235 at this time, or $35 profit.
If you hold a $2.50 put contract at expiration you exercise your put contract, and thus sell 100 shares of SIRI to the put contract writer for $250. The SIRI shares you sold have a value of $235 at this time, for a $15 profit. Each strike price behaves in a similar fashion with profit depending on how far in the money they are.
Given that the last week before options expiration typically sees little to no time value left in those options they will generally trade at the same price or one penny less than the going "ask" for SIRI minus the strike price. You will observe one penny less than the strike price minus the going "bid" for SIRI, on the puts.
This creates a massive opportunity for computer programs which scoop up options as the share price pops up or down a penny, and immediately exercise and sell the shares out into the market. You will see a huge number of options exchange hands and exercise on the last week of options expiration. Most of these come at exactly the same time, as the share price jumps a penny range up or down. If the share price moves quickly, you will notice exponential increases in the number of options scooped up by the computers. This happens because we simple humans cannot react in time to adjust our option pricing within our orders, and the computers can grab them for a penny profit on each. Sure, it's only a dollar, but all those dollars across every single security out there (not just SiriusXM) add up.
The effect of these programs will cause large numbers of shares to be dumped upon the market. Since these programs are concerned only with that single penny, they do not exercise to hold the shares. This is one phenomenon which surrounds options expiration that may skew short data. It will skew selling pressure if call contracts are high, and buying pressure if put contracts are high.
The second effect is observed through action by the option holders themselves. Allow me to explain how I have typically handled my options at or around expiration day.
As a long call holder I have the option of selling the call into the open market to close the position. I also have the option of exercising the call and holding the shares, or exercising the call and selling the shares. I may also choose any combination of the three. I use e-trade and they will not allow me to exercise $500,000 in shares worth of options without the cash available and then turn around and sell them. This is because the price may drop between exercise and sale.
What I usually do is short the shares covered by my long position in call options, then exercise the calls immediately after, and close the short position. I do this because of option contract fees, which are 75 cents per contract, and this can be significant if you are trading thousands of options. For every 1000 contracts you hold, you will end up with $750 in contract fees if you just sell the contracts into the open market. To do what I do costs me roughly $30 for an unlimited number of contracts, thus saving me thousands of dollars.
The problem this behavior-- as well as the behavior individuals who have the cash and exercise and then sell the options-- creates is that it pushes a lot of sales of shares into the market. This can shift the price down temporarily due to the increase in supply. The effect can be limited to Friday and Monday on small open positions, or span Wednesday before to Wednesday after, for large open positions such as January LEAPs.
January 2012 had almost 20 million shares tied up in call options, and if you watched closely, it was quite obvious that the huge sale early in the day down about 8 cents, was to shake the options out of holders' hands, especially at the $2 level -- who feared their profitable positions would suddenly be worthless. Tens of thousands of them were bought up within minutes, as the share price quickly rebounded to previous levels. Whoever made that move made a lot of money on it. The rest of the day found the share price stair stepping down as options were exercised / shares sold.
This is not to say this type of behavior always happens, but it is a good idea to keep an eye out for it. March open positions which are in the money total approximately 7 million shares worth of SiriusXM (11 Million if the share price is over $2.50 by the end of the week), and this is enough to cause some effect on the days leading up to, and following, option expiration on Friday. Since over 90% of these are tied up in call contracts, the effect on the share price will be increased selling pressure for these few days.
Option holders are generally concerned about the profits their options will bring them if they are in the money, and not as concerned about taking possession of the underlying stock. Because of this they are "shares in weak hands" and you can expect nearly all of the underlying shares to be sold to lock in profits.
If you are mindful of this, you can understand a bit of what may cause a small drop near the end of the week and the beginning of the following week. This can also present a nice buying opportunity for those who are seeking to establish a long position, or add to an existing one, as the effect is temporary.
Additional disclosure: I am long SIRI June $2 calls.