Why are stocks more volatile just before the day options expire?

Question

Why are stocks more volatile just before the day options expire?

Answer 1

Because day trading is not based on calculation and it is pure gambling and speculation. They behave irrationally and that makes market irrational too. At the time of closing market behaves volatile because too many day traders moving in to settle.

Answer 2

A stock option is a contract to buy or sell 100 shares of stock. Any options not closed will exercise at expiration, the date in question. To exercise is to buy/sell stock, thus increasing activity. When exercising a call, the owner of the option purchases the underlying shares at the strike price from the option seller, while for a put, the owner of the option sells the underlying to the option seller. Expiration is to exercise.

There are also options on futures and indices which are baskets of stocks that also compound the activity.

Answer 3

Because many professionals whose positions are under water will offset their options in the stock market rather than buy in their options because it's cheaper for them.

Answer 4

Because of the open interest being exercised.

Answer 5

The two previous answers have the right general idea, but are not really accurate in detail.

For an example assume a market maker is short 5,000 calls with a strike price of $50. If the stock is below $50 at expiration the options will expire worthless. If the stock is above $50 he will be assigned and sell 500,000 shares of the stock. Either way, the following Monday morning he wants to have the same position in the stock he had before expiration. That means that if the stock is above $50 he wants to own 500,000 shares that he will sell when he is assigned, but if the stock is below $50 he does not want to own any shares.

Now assume that about a week before expiration the stock is trading for around $50. The market maker would know there was roughly a 50% chance the stock would be over $50 at expiration, so he would probably own about 250,000 shares to hedge is options position. If the stock price went from $49.90 to $50.10 a week before expiration it would not make a big difference in the chance the stock would be over $50 at expiration.

However, if a few hours or a few minutes before expiration the stock price went from $49.90 to $50.10 there is a huge difference in the odds that the stock will be over $50 at expiration. All of a sudden the market maker would go from reducing the number of shares they owned to increasing the number of shares. The market maker suddenly wants to buy 250,000 shares in a short time period due to a small shift in the price of the underlying stock. That increases volatility.

Obviously this does not happen all the time. (For example, if the market maker had been long 5,000 calls instead of short 5,000 his hedges would reduce volatility of the stock.) It does, however, happen often enough to increase overall volatility.

This is a simplified example to demonstrate how volatility can be increased by options expiry.