As the expiration clock approaches zero, the risk in open spread positions will often increase dramatically. Consider a butterfly spread. If the underlying stock is in the money on one leg, the delta of the spread will explode as the in-the-money leg delta approaches 1.0 and the out-of-the-money legs collapse to zero. Increasing delta creates much more rapid price movement, which translates into higher risk and higher potential return. Experienced traders tend to focus more on the high risk aspect of holding butterflies at expiration, and by instinct will close out long or short butterfly trades as soon as possible, to lock in gains or minimize losses before the wild gyrations in spread value kick in.
The simplest way of neutralizing risk is to sell out the entire spread position, if long, or buy back the position when short. When the spread is deep out of the money, it is often cheaper to cover a leg than to buy back the entire spread. Using a -10x20x-10 Short Call Butterfly Spread as an example, if the spread is trading for 0.02 cents and the bottom short leg is trading for 0.02 cents, the trader can neutralize the spread by covering the bottom leg for 0.02 and pay commissions on only 10 contracts, whereas covering the entire spread position costs 0.02 and commissions on 40 contracts. Covering the single leg also leaves open the possibility, however remote, of huge profits if the stock gaps up and the remaining long contracts come back to life.
Things become more complicated if a spread is deep in the money. Liquidity is often non-existent in the ISE Spread Book or CBOE Complex Order Book, and the bid-ask spread on individual options is often prohibitive.
One solution to this problem is to hedge asymmetrically, using put options to hedge call spreads and call options to hedge put spreads. Here is a real-life example from the October 21 Expiration.
The SpreadHunter Team was short GPRO 74.50-75.00-76.00 Put Butterflies going into expiration. We shorted the spread earlier in the week at 0.20 with the expectation that GPRO would move away from the 75.00 strike, in either direction, and we would pocket the 0.20 options premium. GPRO is an exceptionally volatile stock and was trading at 69.00 per share on Friday morning. It was a typical situation of a large potential profit that could get wiped out in an instant. If the stock rallied to 75.00 at the close, our initial .20 profit would now be an 0.80 loss. The liquidity on the spread was zero and the bid-ask spreads on each of the put legs was more than the 0.20 we received when we sold the spread.
Instead of hedging on the put side, a SpreadHunter trader put in an order to buy 74.50 call options at 0.03, which was promptly filled. At this point, if the stock rallied, the call options would kick in and hedge 100% of the risk in the short butterfly position. The 0.03 cost of the hedge reduced the profit on the spread from 0.20 to 0.17, which is significant. But paying up for the hedge set up a low stress Friday afternoon, for this spread at least. For many traders, this alone is worth the price of the hedge.