Index Option Settlements
John
horrific experience on Friday on the option settlement prices. And
since it was pretty unusual, although not uncommon, I thought I would
take the time to go over the index settlement process to make sure
everyone here understands and also to go over what exactly happened and
why it happened.
It's very important for anyone that trades index options to understand
how they work and what the exercise procedures are. There are two
types of index options. Cash settled options and futures settled
options. Cash settled options have an X in their symbol such as the
DJX, SPX, NDX and OEX, these are all cash settled options and they are
European options, meaning no early exercise. Options on ES, NQ, and YM
are futures options and they convert into the underlying contract, the
futures contract. These are also European options.
Please note that OEX are American options and XEO is European. What
this means is that OEX options are available for early exercise while
XEO are settled only on expiration. Otherwise they are the same.
OK, now on to the settlement procedures. Cash settled options are
obviously settled into cash but there is a difference between how the
SPX, DJX, NDX and how the OEX/XEO settle. OEX/XEO options settle at
the close on Thursday before expiration and they use the closing prints
of all the stocks in the SP 100. The SPX, NDX and DJX use the opening
prints on Friday morning of expiration. What this means is that since
all stocks do not open at the same time, a hypothetical number is
generated based on what the index would be if all the stocks opened
simultaneously.
This often confuses people as many times, the settlement price is a
price that never actually traded that day. The reason for this is
because it only uses the opening prints. This means that there can
sometimes be considerable risk in holding these options over Thursday
night and waiting for the settlement price. It's pretty common for SPX
to gap up or down 3 to 5 pts and for NDX to gap up or down 5 to 10 pts.
However, this last expiration, we had a very strong market with a lot
of momentum and it caught a lot of people off guard. The SPX actually
settled 9 pts HIGHER then Thursday close and the NDX settled over 16
pts Higher! And to make matters worse, the settlement prices were
above the highs of the session, meaning that they never actually
traded. This only made some more angry.
There really is no way to hedge this risk except to close all your
options out on Thursday before settlement if they are close to your
long or short strikes. Settlement is a total crap shoot and there is
no way to play it consistently.
So please keep this mind for all of you that trade index options. One
bad settlement can really ruin your month or even your whole year. Not
worth the risk.
John