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January Option Expirations: One For The Ages


This January's expiration is huge beyond comparison in open interest and options are as cheap as I have ever seen.

Although January expirations for equity options are always the largest of any (long term leaps traded over years always expire in January), this January's expiration may be one of the largest ever for the U.S. equity market. That is a function of several things, like the growth in stock capitalization and in the number of investors and traders.

But the main driver of this has been the absolutely huge amount of option selling done by lots of new closed end funds created to specifically sell option premium. This strategy is certainly not new and was almost as big in the mid 1980's. Most of those funds met their demise in the crash of 1987.

There are two problems with the strategy. First, investors in these funds may have a vague sense of the risk, but they don't really understand the magnitude of the potential risks. They earn moderate returns in normal markets, but when volatility picks up significantly they wind up shocked at the losses. This causes withdrawals and "forced selling at the bottom," the worst mistake investors can make. And it is in fact this mis-understanding of risk that can actually cause the pick up in volatility. The second is related. It is one thing to sell an option when it is high in price and the risks are known, but quite another to sell it cheap and not earn an appropriate return for the risk. Cheap options have higher gamma and that acts like leverage. Leverage increases not only return but risk, something people "forget." Funds with a strategy tend to do it systematically. It is hard for them to stop just because options get cheap, for if they do they don't get paid.

In the crash of 1987 mutual fund investors at least knew the risks and many didn't sell at the bottom. "Buy-write" fund investors didn't and almost all wanted out at the bottom, thus making the correction turn nasty.

Today these funds have learned only one lesson: they set the funds up as closed end funds so investors can only get out by selling the "stock" of the fund at their own peril. Managers of the fund don't have to liquidate the underlying assets of the fund.

They haven't learned not to sell options cheaply. This January's expiration is huge beyond comparison in open interest and options are as cheap as I have ever seen. Some individual stock options have implied volatilities around 10. These are not bonds folks.

Nothing may happen, but the probabilities are there for a pick up in volatility. The option sellers may get a call while they are on the golf course.
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