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Feeling Unsettled by Settlement Values

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Equity option traders have an advantage over index traders. On expiration Friday, they have a fairly accurate idea whether their options ended up being in, at, or out of the money. Option traders in cash-settled index options may be far off the mark, however. Settlement values often deliver unpleasant surprises to them.

We'll look at some recent surprises later in the article. First, a brief explanation of settlement prices might be needed for those relatively new to options trading.

The CBOE defines settlement price as the "official price at the end of a trading session." The Options Clearing Corporation calculates that settlement price. It's that calculated value that determines whether index options are in, at, or out of the money at expiration. Cash is then delivered to the accounts of the traders who hold long options that settled in the money and subtracted from the accounts of those who hold short options that settled in the money. For example, if a trader's account held a long SPX call that settled in the money by one point, $100 ($1.00 x 100 multiplier for SPX options) would be deposited in that trader's account. If the trader had written or sold a call that settled in the money by one point, $100 would be deducted from the trader's account.

That's all easy to determine and instinctive to understand. The hard part is figuring out exactly what those settlement values are.

Most of those cash-settled indices settle on Friday morning of opex week rather than Friday afternoon. RUT, SPX and DJX are three commonly traded cash-settled index options that usually settle on the morning of opex Friday. Front-month options for those and most other cash-settled indices stop trading as of the Thursday close before settlement Friday. The OEX and XEO options are frequently traded exceptions to this rule, however. Both trade all day on opex Fridays and settle at the close.

The problems and the nasty surprises come from the way the settlement values are determined. For example, as most experienced traders know, settlement values for indices that settle Friday morning are not the first or opening values of the underlying index at the open on opex Friday. Instead, the settlement price or value for these cash-settled indices is, in the words of the CBOE, "calculated using the opening sales price in the primary market of each component security on the last business day (usually a Friday) before the expiration date." So, if we're talking about the SPX, for example, they'll calculate the settlement value by inputting the opening price for Agilent Technologies, Alcoa, Apple, AmerisourceBergen, Abbott Laboratories, and on down the line through all the component stocks.

As many traders already understand, not all securities in a particular index open at exactly the same time, particularly for a big index such as the RUT, with 2000 components. Imagine that there's a big gap lower at the open on the RUT, with 1200 components printing their opening values right at the open. Imagine that a bounce begins within seconds and, as another 400 open in short order, they begin opening higher than they would have done a few seconds previously. The bounce catches on and succeeding opening values for the last 400 components are impacted more and more by the bounce underway. Imagine then that, within five minutes of all the components opening, the RUT rolls over and heads down all day. Although it's hard to understand, that early bounce that was sending the last 800 component stocks into higher opens may actually have resulted in a settlement value for the RUT that is higher than any RUT value that was hit that particular day. The opposite effect can occur, too.

A couple of years ago, I wrote an article detailing some of the then-recent settlement-value flukes. For example, on Friday, November 18, the SPX opened at 1242.80 and hit a day's high of 1249.58, but the settlement value was 1254.85. Moreover, the close the previous day had been only 1242.80. Those who had credit spreads with a sold call at 1250 might have thought their positions safe on Thursday evening and doubly safe with Friday's open, but instead $485 per contract would have been deduced from their accounts when those 1250 calls settled in the money by $4.85. Many iron-condor traders with sold strikes at 1250 had reason to rue that November settlement value.

Another previous article detailed the RUT's sometimes extreme deviation from Thursday's closing values to Friday's settlement values. These days, big opening gaps have become more prevalent than they used to be, so traders understand they need to discount the possibility of a gap up or down the Friday morning of opex week. However, some traders who might accept that Friday morning's opening index values might be much different than Thursday's close might still not have factored in the very real differences in Friday morning's opening values and settlement values.

The CBOE lists settlement values for the OEX, SPX, VIX, Dow Jones Industrials, RUT and NDX options at this link. The following table incorporates some of those CBOE-provided settlement values as well as information gathered elsewhere. "THUR CLOSE" references the SPX closing value for the Thursday of opex week in each listed month. "FRI OPEN" references Friday's opening value, with both the Thursday closing and Friday opening values drawn from DTNIQ feeds. "SET" is the symbol for the SPX's settlement value.

2009 SPX Settlement Values:

As should be apparent, at least one nasty surprise awaited some traders. Those in JAN call credit spreads with the sold strike at 850 were going to be hurting that opex Friday. Although the SPX closed Thursday and opened Friday well below that sold strike, the settlement value was $9.37 above it. Those who might have bought a cheap JAN 850 call as a speculation trade were, however, happily surprised.

Other oddities that might not be quite so apparent from this table are those instances when a settlement value turned out to be higher than any value the index hit that day. This event occurred three separate times in 2009: January, March and April.

Those who want to find settlement values for their favorite indices can do so by using the symbol for the settlement value. Some common ones include SET for the SPX, RLS for the RUT, DJX for the Dow Jones Industrials, and NDS for the NDX.

Be careful when looking for those values the Friday morning of opex week. Each takes some time to calculate, so it's possible that you could be looking at a SET value that not current if you check too early. I don't usually have front-month options open in opex week, as I like to close my income trades before opex week. When I did tend to have those trades open during opex week, however, I always checked early, so that I could see what the previous day's number was and then be able to determine when it had been updated. RLS takes an interminable amount of time to calculate, and it may be well into the afternoon of opex Friday before the current value is updated.

The OEX's settlement symbol is OEX, and, although supposedly that value could be as far off Friday's closing values as other indices' settlement values are off Friday's opening values, I haven't found that to be true. The times I've been paying particular attention because I'm in OEX options, the last charted value for the OEX appears to be the settlement value. I wouldn't trust that impression, though, as it's not supposed to be true.

Whether that's true or not might be a good question for the CBOE's "Ask the Institute." What is true and not open to debate is the following: now more than ever before, it may be especially important to be careful about going into opex Friday with sold strikes open, even if they seem far out of harm's way.

Linda Piazza

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