Option-Expiration Week Effect

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 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 a main reason for the abnormal stocks' 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.

Markets traded
equities
Confidence in anomaly's validity
Strong
Notes to Confidence in anomaly's validity
Period of rebalancing
Weekly
Notes to Period of rebalancing
Number of traded instruments
1
Notes to Number of traded instruments
Complexity evaluation
Simple strategy
Notes to Complexity evaluation
Financial instruments
stocks, CFDs, ETFs, futures
Backtest period from source paper
1988-2010
Indicative performance
9.30%
Notes to Indicative performance
per annum, calculated as return for holding stocks during 12 option expiration weeks (6,3%) plus expected return on cash position (3/4 multiplied by ~4%), stocks return is calculated as weekly return of 0.528% multiplied by 12, data from table 3
Estimated volatility
8.70%
Notes to Estimated volatility
used data from table 3, estimated volatility for portfolio which is 1 week from month in a stocks and 3 weeks from month in a cash
Maximum drawdown
not stated
Notes to Maximum drawdown
Sharpe Ratio
0.61

Keywords:

seasonality, market timing, stock picking

Simple trading strategy

Investors choose stocks from 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 option expiration week and stays in cash during other days.

Hedge for stocks during bear markets

No - Strategy is timing equity market but invests long-only into equity market factor (even that only for a short period of time) therefore is not suitable as a hedge/diversification during market/economic crises.

Source Paper

Stivers, Sun: Option Activity and Stock Returns During Option-Expiration Weeks
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1571786
Abstract:
Over 1983 to 2008, we find that large-cap stocks with actively traded options tend to have substantially higher average weekly returns during option-expiration weeks (a month's third-Friday week), with little difference in weekly return volatility. This difference in average weekly returns is evident in two dimensions, both relative to the other non-third-Friday weekly returns for the respective stock and relative to the third-Friday weekly returns for smaller stocks. By contrast, the average third-Friday weekly stock returns are not different than other weeks over a pre-option-market sample period from 1948 to 1972. To probe further, we investigate ties to option open interest and option volume. First, we find that option open interest decreases appreciably during the third-Friday week and that call trading is high during the third-Friday week, relative to both the underlying stock volume and the put volume. Second, patterns in call trading by non-market-makers suggest that the call-related delta exposure of market makers tends to decline appreciably during the option-expiration week. Third, we find that the average weekly stock returns are especially high for option-expiration weeks that also experience a high call trading volume, relative to the underlying stock volume. Along with related recent literature, our collective findings suggest that intra-month weekly patterns in call-related activity contribute to patterns in weekly average stock returns, with hedge rebalancing by option market makers being a likely avenue.

Hypothetical future performance

Strategy's implementation in QuantConnect's framework (chart+statistics+code)

Other Papers