Option Investor
Trader's Corner

The Least You Should Know

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It happened again this month. A subscriber contacted me during expiration week. It was clear from this person's comments that this subscriber did not know that the futures that were the subject of the email were about to expire: the next day, in fact. This subscriber did not know what time of day this futures contract stopped trading or how or when the settlement figure was calculated. The subscriber didn't know how much would be gained or lost for each move up or down in the commodity price in the interim, but rather was just studying the profit/loss update provided by the subscriber's online broker. The subscriber didn't know whether the futures contract being discussed was cash-settled or would be settled with physical delivery of the commodity.

Yikes. You really do not want a pile of pork bellies or some such thing being delivered to your doorstep because you didn't know that expiration was upon you and whether the contract was cash-settled or not.

That was a futures contract, but the same thing happens often with subscribers asking about options plays. Since this site focuses on options trading, we're going to discuss the least you should know before you even entertain the idea of entering an options play. After that, I'll discuss a calculation that I haven't seen explained elsewhere, but that is also the least you should know if you're holding an option as expiration approaches. This idea might help you make end-of-day decisions just before an option stops trading. This is particularly true for those of you who trade credit spreads, selling options as part of the spread. Those of you who already know the basics of options expiration can skip to the last half of this article for that information. Newbies need to read it all.

The least you should know before entering an option play is how much you're going to pay, where the underlying has to be for you to make money on that option when it expires, when the last trading day is, when it settles, and how the settlement value is determined. Of course, the least you should know also includes how much of your account you should devote to one position and how much you're willing to lose before you're stopped, but that's true of any trade, and this article will focus only on the particulars of options. You also need to know how an option moves when the underlying does and according to other factors, but that's also a topic for another article, one I've written in the past. This article focuses on settlement.

Before you can determine how much you're going to make if you happen to be holding an option into settlement, you first need to calculate how much you're going to pay. You need to know the multiplier for that option. Perhaps you see an option quoted at 1.95 bid and 2.25 ask, and you figure you'll offer 2.15 to buy it. You're going to pay some multiple of 2.15 for each contract of that option, if you're so lucky as to have your offer accepted. In most cases, that multiple is $100, but it isn't always. Don't assume it is. For example, if the option is on an equity and a stock split has occurred, the multiplier might be different. Check.

This information can often be found at www.cboe.com for options on both equities and most indices. Clicking on the "Products" tab presents you with a choice of equity options, index options interest-rate options and other choices. For example, you can follow the links through to the Russell 2000, and find that the Russell 2000's options do indeed have a multiplier of $100. If that were a Russell 2000 Oct. 770 call you had bought for 2.15, you'd have paid $215.00 for each contract, plus commissions.

That Oct 770 call might have been trading at about that level some time on opex Wednesday or Thursday. If you'd been buying that October contract on Wednesday, October 18, you had better have known that it was option-expiration week for the Russell 2000 options, as well as for other index and equity options. You needed to know the expiration date before you decide whether you'll buy a front-month (the current month) option or one further out. You don't want to buy a front-month option if it's opex week and you're legging in for an anticipated movement that might not happen until the next week, for example. Your front-month option will expire before then. The CBOE helps you out there, too, publishing an expiration calendar at http://www.cboe.com/AboutCBOE/xcal2006.pdf/ with another also already available for 2007.

October's expiration was October 21, but even that's not enough information. That's a Saturday. Obviously, the Russell 2000's options do not trade on a Saturday, so when would the October options stop trading? Some indices stop trading at the close the Thursday before option expiration; some on the Friday before opex. And when is a settlement value determined? Some settlement values are determined when markets open the Friday before option expiration and some at the close.

The RUT turns out to be one of the indices with options that stop trading Thursday afternoon and settle Friday morning, although you might not find out what that settlement value is until the afternoon. This next statement has been repeated often, both by me and by others, but bears repeating again: the settlement value is NOT the opening value for the Russell 2000 Friday morning. The settlement value is calculated by the opening value of all the component stocks. They don't all open at the same time, so if markets are declining near the open, even for a few moments, with prices cascading lower, the stocks opening a bit later than the first ones are likely to be hit and the settlement value could possibly be below the opening value. The opposite can happen when there's a buoyant mood in the markets, even if it lasts for only a few moments and the rest of the day is a down day. All this information about how settlement values are calculated is available on the CBOE site under product specifications for each option series.

On opex Thursday, the Russell 2000 closed at 767.39. The options stopped trading as of that close. If you had bought the 770 calls, doesn't that mean that you were out of luck and you lost that $215 plus commissions that you paid? If you had sold those options as part of a spread, does that mean you were safe? Not necessarily, in either case. Settlement value could have been radically different from Thursday's closing price as was stated in the paragraph above and as will be demonstrated later in the article.

If you'd been a buyer of that option and had held onto it that Thursday, where would the Russell 2000 have had to have settled in order for you to make money? It would have had to have settled above 770 (the strike you bought) + 2.15 (the price you paid for the option), and of course you'd have to add in your commission, too. If the settlement was above that price, then you would have been in luck.

A call option gives the call buyer the ability to buy at the strike price. If the underlying settles above that strike, the call is considered in the money. If you've bought a call on an equity or index and the call is in the money by an amount that your broker determines (mine says $0.05) at expiration, you're either going to find some money or some stock in your account.

If you bought a Russell 2000 call and the settlement had been above $770, were you in danger of having a bunch of Russell 2000 component stocks dumped into your account, with the need to pay for them? Nope. The RUT is cash-settled, information that's also found on the specifications page for the Russell 2000. Because the RUT also has European-style options, you don't have to worry about those options being exercised before opex, either. They are exercised only on the last business day before expiration.

If you had bought that Oct 770 RUT call on Wednesday, you could have sold it before option expiration, of course, and you may have wanted to do so. The least you need to know about options also includes the fact that their extrinsic value decays as time passes. An option's price is composed of its intrinsic value, the value by which it's in the money, and extrinsic value, commonly referred to as its time premium. That commonly used term is not the whole truth because there are other factors that go into an option's price other than time value, but if you paid $215 for a contract of Russell 2000 calls on the Wednesday of opex week, the truth was that all of that value was extrinsic value. With option expiration quickly approaching, that call's value was likely to begin decreasing rapidly if the Russell 2000 did not move up, and move up quickly on opex Thursday.

There's a tendency for prices to be pinned to certain numbers beginning about mid-morning on option expiration Thursday while premium evaporates out of those out-of-the-money options. Especially if trading during opex week, be aware of this tendency, the least you need to know about choosing options during opex week. If you have the opportunity to make a decent profit on an out-of-the-money option earlier in option-expiration week, you might want to consider taking that profit or at least locking in some profits. If the option is underwater as expiration approaches and you have to opportunity to recoup some of your losses, you also might want to consider taking that opportunity.

If you had held on to the call you'd bought until the last moment, you would have had to have made the last-minute decision as to whether to sell it or hold onto it that Thursday afternoon. If you had sold the option and not bought it, perhaps as part of the spread, you also had to decide whether you wanted to buy-to-close that option or just wait out settlement the next morning, fingers crossed. Thursday's close was out-of-the-money, but would the settlement value be?

That's always a tough decision because anything can happen overnight. That's one reason I traded OEX options so long. They trade through opex Friday and settle at the close Friday. Although there were still some nasty surprises with settlement, you at least got to look at where settlement was likely to be when you're making that last-minute decision. When you make that decision on the RUT or the SPX, for example, you're making it Thursday at the close, not knowing what might happen overnight that could conceivable impact the open the next day.

The last least thing you need to know isn't often addressed. How far is the Russell 2000's settlement value likely to diverge from Thursday's close? Does the settlement value tend to be near Thursday's close or far from it? Although few writers address this issue, it's important for option buyers and sellers to know.

As has already been mentioned, the RUT closed at 767.39 on opex Thursday. Below, you'll find a table that displays the bid and ask for the Oct 770 as of Thursday's close.

Quote for the Russell 2000 Oct 770 Call as of the 10/19 Close:

As you can see, the bid and ask were 1.10 x 1.35. If you had been a buyer of that 770 call, should you have sold it at the close and taken your lumps after buying it for a higher price on Wednesday, but be grateful that you could collect anything for an out-of-the-money option? Should you hold on, hoping for a settlement value the next morning above 771.15? (This figure is the strike of your option, 770, plus an estimated 1.15 you might have been able to collect if you'd sold your call option Thursday afternoon, so represents where the RUT would have to settle for you to have been better off to have held it than to have sold it and taken your lumps Thursday afternoon. It does not represent a profit on the position, which wouldn't occur unless the RUT had settled above 772.15 plus the commissions you paid.) If you'd been a seller of the option, should you have bought it back near the close on Thursday, or held on and hoped that the RUT would settle below $771.25. (This is the strike plus the estimated $1.25 you would have had to pay to buy-to-close that option.)

To know that answer, you'd have to have had some idea how far the Russell 2000 typically settles above or below opex Thursday's close. That's the only way you were going to have any idea how much hope you might have had of recouping anything if you were a buyer of the option and decided to hold, or how much risk you might have had of shelling out some money if you were a seller of the option and decided to hold. The following table displays Russell 2000 closing prices on opex Thursdays for a year leading into October, as well as the corresponding settlement values determined on Friday morning, and the differences between those values.

The Difference of Russell Closes on OPEX Thursday and Settlement Values on Opex Friday:

If you use absolute values and average those, the average difference from opex Thursday's close to Friday's settlement is actually 3.155. However, you can see that three of the numbers--October 2005's, November 2005's and April 2006's--are far out of the norm. Averaging the other nine months produces an average of 2.53, relatively in line with the average difference listed above.

Each can have a different opinion, but it's my opinion that when making that choice about which figure to use that it would be better to use a difference calculated using the absolute value of the differences in the individual months. If October's opex had been average, the Russell 2000 might then settle 3.16 points away from Thursday's close, in either direction, since we're talking absolute values here. If you had been a buyer or a seller of the option, you were risking an average settlement that could be from 764.23 to 770.55, with each number 3.16 points away from the opex Thursday close of 767.39.

If you had been a buyer of that option, you could have calculated that the average settlement difference would still not result in an option that was in the money by the 1.15 or so that you might have been able to fetch for your call on Thursday afternoon. The average difference, absolute-value method, wouldn't come close to a figure above 771.15. You might have decided that the best course was to sell the call. Studying the chart further would have told you that four of the last 12 months saw positive differences big enough to bring that 770 option into the money, but only three of those would have resulted in a better position than selling at the close on opex Thursday. For the option buyer who might have bought the option on Wednesday, then, it appears that it would have been a better bet to have sold the option at the close and taken the loss, at least avoiding the potential for an even greater loss if settlement was within the average value.

If you had been a seller of that 770 call, you might have had a different outlook after studying that same chart. If the RUT settled 3.16 points above the opex Thursday close, or at 770.55, you were going to owe 0.55, the amount by which the call would have been in the money, so $55.00 per contract, plus the amount you'd be out your commissions.

That's less than the debit you'd have had to have paid to close out the position at the close on opex Thursday, however. Nine out of the twelve months, the option seller would benefit by holding pat and not doing anything, taking the risk of a bigger than average jump.

However, three of those months would have resulted in bigger losses for the option seller, and two of them would have been really big losses. What the option seller might have decided to do should have depended on the number of contracts sold, the account size, the option seller's tolerance for risk, and the state of the option-sellers stomach! Nine out of 12 chances of benefiting sound like good odds, but when the RUT settlement gets odd, it can get really odd! If you'd had one contract, you might have been prepared to stomach a few-hundred-dollar loss if you got a weird settlement value: if you had 20 or 30 contracts, the decision would have been tougher, but at least you were armed with this vital information.

So how did the RUT settle that Friday in October? The settlement value, RLS ($RLS on QCharts) was 770.06, 2.67 points above the opex Thursday close. This was a smaller one than the 3.16 one calculated using absolute values, which I think is probably the best to use, but roughly in line with the average calculated by the regular method, somewhat arguing against my opinion about the absolute value average. The RUT opened and moved up briefly but then dove through the early session. It never got anywhere near 770.06 that day, but that's how settlement works. Because it opened and climbed for just a few moments as component stocks were opening in domino fashion, the settlement was higher than the 768.32 high of the day.

If you'd been a buyer of that call option, it would have been better to have sold that option the day before; if you'd been a seller of the option, it would have in this case also have been better to hold out, paying only 0.06 (or $6.00 per contract) rather than the debit it would have cost you to buy it back near the close on opex Thursday. If you'd looked at the average difference between opex Thursday closes and Friday's settlement values, you would have been armed with vital information to make your decision. If you had been willing to accept the risk of a weird and out-of-whack settlement such as those few on the table above, you'd have been rewarded. I can't say it would have been a bad idea to close out the options, either, if your account could not stand the possibility of the kind of larger loss that occurred two months out of the previous year or if you couldn't stomach that possibility. Knowing the least you should know would have prepared you to make that decision.

Like many of you, I had been a seller of the 770's as part of a bear call spread. In fact, I'd sold 24 contracts of them. My decision? After performing all these calculations for myself on opex Thursday and looking at the bid/ask spread needed to buy-to-close that 770 call, I decided to take my chances and not close out the spread. I did throw out a low-ball order to close it, knowing that it was so low that it probably wouldn't be taken, and it wasn't, but it was worth the try anyway.

My decision turned out to be a good one in this case, and I retained most of the credit I'd collected when initiating that spread. It won't always turn out to be the right decision, as those sometimes-weird settlement values show. The average was on my side this time, and knowing the least I should know helped me make that decision.

Do your research, too. It's the least you should know.

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