Option Investor
Trader's Corner

Let's Settle This

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Last December, a trader submitted a question to the CBOE's educational "Ask the Institute." The question concerned SPX settlement values. I knew without looking at the remainder of the question which opex cycle had prompted the question: the November 2005 SPX settlement. I had felt the pain of that particular option-expiration settlement value along with a lot of other sufferers, and I remembered it well.

The SPX had closed Thursday, November 17 at 1242.80. Those who had written or sold the November 1250 call probably felt fairly confident, if perhaps slightly nervous, that their sold calls would expire worthless the next morning.

They were to be proved wrong. Although the next day saw an SPX open at 1242.80 and a day's high of 1249.58, the settlement value was 1254.85. That weekend, those who had written the 1250 call got messages from their brokers that their sold calls had expired in the money, and that their accounts were being docked the appropriate $485 per contract, plus any commission for closing the position.

How did that happen, the trader questioned in the email to CBOE's "Ask the Institute." Such questions get asked all the time. When I was writing for the Market Monitor, I knew to prepare for a spate of last-minute questions about when certain options expired, with those questions often arriving mid- to late-afternoon on Thursday of option-expiration week. Those questions probably should have been asked before a trade was initiated, but even experienced options traders and commentators sometimes get mixed up. Let's settle some misconceptions about options expiration.

First, while many current-month index options--the DJX, NDX, SPX, RUT and SOX, for example--stop trading on Thursday at the close and have settlement values determined when their component stocks open Friday morning, not all do. OEX options trade through Friday and have settlement values determined by component closing values Friday afternoon. This is true of both the American-style OEX options and the European-style XEO options.

If you're trading index options, know when they stop trading and when they settle. Calendars provide option, equity and currency expiration dates, and those can be found one at least two sources. Those who signed up for a year's subscription to OptionInvestor received a mouse pad with that information. It's also available at the following Yahoo.com site:
http://biz.yahoo.com/opt/calendar.html

You need more specific information, however, to determine stop-trading and settlement times. Go to the exchange that handles the options for that information. For example, copying and pasting the following link provides detailed information on the SPX's expiration, for example:
http://www.cboe.com/Products/indexopts/spx_spec.aspx

That CBOE page contains a sentence that explains why so many were dismayed by the SPX's settlement value on November 18: "The exercise-settlement value, SET, is calculated using the opening (first) reported sales price in the primary market of each component stock on the last business day (usually a Friday) before the expiration date."

While it's possible that the settlement value and the opening value of the index are close, that's not necessarily true. If markets are buoyant near the opening, as happened November 18, each SPX component may be opening higher in domino fashion, even if the original sales price is soon knocked back, even by the time other components have opened. The compilation of all the first sales prices on each of the 500 components may reach a high that the index itself never sees, as happened that November day. Included in the answer, the "Ask the Institute" commentator noted that this unusual settlement value scenario tended to occur a few times one year, but then would not occur for another year or so.

In other words, it was a fluke, but totally legit. I'm certain that commentator would warn that while a settlement value twelve points above the previous day's close might be unusual, it's always possible for a settlement value to be off-kilter by several points and that possibility must be factored into the decision about whether to close out an expiring options position on Thursday night or hold it overnight and wait out the settlement value.

The fact that OEX options continue trading Friday and don't settle until the close on Friday erases some of the danger, but not all. If prices are cascading lower into the close, for example, the settlement price might be several or even many points lower than the OEX's closing price. Still, the overnight risk is removed, and that tempts some options traders to focus on the OEX rather than the SPX. The tradeoff for erasing that risk is seeing extrinsic value pour out of your option while equities and indices are pinned beginning about mid-morning Thursday, with the loss of extrinsic value accelerating Friday.

You won't find settlement information for all indices on the CBOE. If you want to find stop-trading and settlement information for the SOX, for example, you'll have to go to the Philadelphia Stock Exchange. Copying and pasting the following link will supply you with the information on the SOX:
http://www.phlx.com/products/sox.html

If you're trading XAU options, you'll find information on them at the Philadelphia Stock Exchange's site, too. There, you'll find that they expire on a three-month cycle rather than a one-month cycle. The OSX, another commodity-related index with options listed on the PHLX, also expires on a three-month schedule, but the two have different stop-trading and settlement times. The XAU options stop trading the last Friday prior to expiration and settle based on the close of the component stocks that Friday, while the OSX options stop trading on the last business day before the third Friday of the expiration month and settles based on the open of the component stocks the next morning. Don't assume that because both indices are commodity-related and have three-month cycles that their settlements are the same.

In fact, don't assume much of anything about stop-trading or settlement when you're dealing with index options. Do your research, and do it before you initiate the trade.
 

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