It’s that time of the month again – for options traders that is. Friday is January monthly options expiration and now is the time when you can see the hands of large open options positions play out. There is a lot happening in these final 2 days of options expiration. The big players are rolling or unraveling their options positions. One of the most attractive opportunities of options expiration is something called Options Pinning. This is when a stock gets “pinned” at a strike price with the highest open interest. This typically happens because market makers who sold a large amount of options at a specific price also bought the stock or shorted the stock in order to remain “delta neutral”. On options expiration day market makers will start unraveling their position by buying or selling the stock, thereby “pinning” the stock at that high open interest strike price and, if short the option, collect the premium they sold.
What I look for is a strike price on a highly active stock that has open interest of at least double that of any other strike price (calls and puts combined). The larger the disparity the more likely the pin. Take for example the below screen shot of GOOG. At the 700 strike the open interest is over 12,600 which is more than double that of any other strike price. Also, keep in mind you want the current price to be relatively close to that of the strike price. In this case a 15 point disparity in GOOG is close to its daily range. In fact the daily average true range for GOOG is $13.
So what’s the highest risk/reward ratio you can utilize with options to take advantage of this phenomenon? Welcome to the world of butterflies. First thing to know about butterflies is (in my opinion) you never, ever, sell a butterfly. Not even with your mother-in-laws money. You always buy a butterfly. When you buy a butterfly you’re selling a strike price and buying the strike prices of the next strike above and below it. So for GOOG you would:
sell two January 700 puts and then buy one Jan. 695 put and buy one 705 put.
Those puts that you bought are known as the wings of the butterfly. What a butterfly does is give you a very limited risk, but maximizes the reward if you’re right about the pin at 700.
In the below screen shot you can see a butterfly I bought today. This involved selling 200 of the Jan 700 strike GOOG puts and buying 100 695 puts and 100 705 puts. The max loss is $3,900 – always remember to include commission costs especially with a butterfly as they will add up. However, the potential max profit is $46,700. Now that is an awesome risk/reward.
What’s the likely hood of GOOG going to 700? Well we can use a tool in think or swim called the “probability of out of the money”. This will give us the probability that an options strike price will expire out of the money and therefore worthless. The screenshot below shows you that the Jan 700 puts have a 89.44% chance of expiring out of the money. Therefore this butterfly has about a 10% chance of making money. However, the risk/reward ratio on the trade is 12 to 1. If you did this trade 10 times and it only worked out once this trade would have a 33% return. That is a return on investment most traders can live with.