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The option-expiration week is a week before options expiration (Friday before each 3rd Saturday in each month). Large-cap stocks with actively traded options tend to have substantially higher average weekly returns during these weeks.
A simple market timing strategy could be therefore constructed -> hold the largest stocks during the option-expiration weeks and stay in cash during the rest of the year.
Fundamental reason
Academic research suggests that intra-month weekly patterns in call-related activity contribute to patterns in weekly average equity returns. Hedge rebalancing by option market makers in the largest stocks with the most actively traded options is the main reason for the abnormal stock's returns. During option-expiration weeks, a sizable reduction occurs in option-open interest as the near-term options approach expiration and then expire. A reduction in call-open interest should be associated with a reduction in the net long call position of market makers. This implies a decrease in the short-stock positions being held by market makers to delta hedge their long call holdings.
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Market Factors
Confidence in Anomaly's Validity
Period of Rebalancing
Number of Traded Instruments
Complexity Evaluation
Financial instruments
Backtest period from source paper
Indicative Performance
Notes to Indicative Performance
Estimated Volatility
Notes to Estimated Volatility
Maximum Drawdown
Notes to Maximum drawdown
Sharpe Ratio
Regions
Simple trading strategy
Investors choose stocks from the S&P 100 index as his/her investment universe (stocks could be easily tracked via ETF or index fund). He/she then goes long S&P 100 stocks during the option-expiration week and stays in cash during other days.
Hedge for stocks during bear markets
No – The strategy is timing equity market but invests long-only into equity market factor (even that only for a short period of time); therefore, it is not suitable as a hedge/diversification during market/economic crises.
Out-of-sample strategy's implementation/validation in QuantConnect's framework(chart, statistics & code)
Source paper
Stivers, Sun: Returns and Option Activity over the Option-Expiration Week for S&P 100 Stocks
Abstract: For S&P 100 stocks, we find that the weekly returns over option-expiration (OE) weeks (a month's third-Friday week) tend to be high, relative to: (1) the third-Friday weekly returns of other stocks with less option activity, (2) the own stock's other weekly returns, (3) the risk, based on asset-pricing alphas. For these same stocks, a month's fourth-Friday weekly returns underperform modestly. We suggest the following two avenues are likely partial contributors towards understanding these return patterns: (1) delta-hedge rebalancing by option market makers, with a reduction in short-stock hedge positions over the OE week, and (2) declining risk perceptions over the OE week, as measured by option-derived implied volatilities. Our findings suggest option activity can induce reliable patterns in the weekly returns of option-active large-cap stocks.
Other papers
Cao, Jie and Chordia, Tarun and Zhan, Xintong, The Calendar Effects of the Idiosyncratic-Volatility Puzzle: A Tale of Two Days?
Abstract: The idiosyncratic volatility (IVOL) anomaly exhibits strong calendar effects. The negative relation between IVOL and the next month return obtains mainly in the third week of the month. The IVOL-return relation is generally negative on Mondays and positive on Fridays. However, the positive impact is absent on the third Friday due to selling pressure from stocks delivered at option expiration. This imbalance between the negative and positive returns during the third week of the month has a large impact on the IVOL-return relation. Removing the third Friday and subsequent Monday return reduces the monthly IVOL effect by at least 40%.
Mohamed, Hussein: Time-Based Trading Patterns
Abstract: The research paper investigates the influence of various calendar anomalies on stock market returns across multiple indices, including the S&P 500, S&P 400, S&P 600, Russell 1,000 Growth, and Russell 1,000 Value. The study provides a comprehensive analysis of both individual and interaction effects of several well-known calendar anomalies, challenging the conventional understanding that these anomalies occur in isolation. The calendar effects studied include the Federal Open Market Committee (FOMC) meetings, Options Expiration Dates, the Holiday Effect, Sports Events Effect, Halloween Effect, Turn-of-the-Month Effect, January and September Effects, as well as Friday and Monday Effects. The research applies advanced regression techniques, incorporating an ARMA (1,1) model and an EGARCH (1,1) model with a t-distribution to account for both autocorrelation and volatility clustering in stock returns. The ARMA model, with exogenous variables representing the calendar anomalies and their interactions, captures the linear dependencies in return series. The EGARCH model further analyses the persistence and asymmetry in volatility, revealing how negative market shocks tend to increase volatility more than positive shocks. These models effectively highlight the impact of calendar anomalies on both the returns and volatility of the studied indices. The findings reveal that the Halloween Effect was the most significant anomaly observed, particularly impacting indices such as the S&P 500, S&P 400, S&P 600, and Russell 1,000 Value. These results suggest that this anomaly can be strategically leveraged by investors to optimize returns. While the research highlights the potential for using calendar anomalies as part of a time-based trading strategy, it also notes that the effects may vary across different indices, reflecting the unique characteristics of each market segment. The study contributes to the broader discourse on market efficiency by offering practical insights for investors and suggesting that these calendar-based anomalies may present exploitable opportunities within financial markets.