Recently, I've mentioned that although I used to employ the European-style XEO for my iron condors, I'd switched back to the American-style OEX. I'd experienced a few minor problems with fills. I knew the American-style OEX options had higher open interest in some strikes. At the same time, I also switched to the OEX for my iron butterflies, traded in smaller size than my iron condors.

When I made that switch for the butterflies, I had forgotten about a conversation I'd had with my broker many years ago. I'd been talking about early expiration risk. Assuming there was still extrinsic value in a cash-settled OEX option, I couldn't believe that anyone would exercise such an option.

For example, imagine that as of the close December 18, someone held a JAN 505 call. The mid-price of that call was $11.50. With the OEX closing at 508.73, only $3.73 of that call's value was intrinsic value. $7.77 of that was extrinsic value, what some call "time value." Because the OEX is an American-style option, a settlement value (OEX) is calculated each day, based on the closing values of each OEX component. The person who exercised an in-the-money long call would then collect cash in the amount the settlement value was in the money, so $3.73 in our example.

Why would someone choose to exercise that call and collect only $3.73 when that person could have sold the call on the open market for something near $11.50? That didn't seem logical. My broker assured me that there were cases when it might happen. Hurray, I thought. If I'd sold a call that still had lots of extrinsic value, also sometimes called time value, then I'd likely sold it for more than $3.73, and I'd love to be keeping the rest of that money in my account.

But maybe that early exercise risk, however minimal, was more logical than I thought. Lately I've been privy to a lot of conversations about the OEX versus the XEO, and particularly about whether the choice between them depended at all on whether the chosen strategy involved selling at- or in-the-money options or far out-of-the-money options. After all, those of us trading iron condors are selling options so far out of the money that there's hopefully never going to be any intrinsic value in those options. If there is, then we've let the trade go bad, with the prices moving across our sold strikes. Barring some sort of huge move that gaps prices across my sold strike, that's just not something I would allow to happen in my own trading.

But what about those iron butterflies I had been trading? A sort of smushed-up iron condor, iron butterflies involve selling at- or near-the-money calls and puts. Long calls and puts are bought further out to form the wings and hedge the sold options. If the OEX were to move anywhere away from the middle of that iron butterfly, a likely event unless the OEX is just going to sit right at the same level throughout the duration of the trade, either the sold put or the sold call would gain some intrinsic value.

So what, I thought, but then I remembered back to that earlier conversation. And then I remembered something a former market maker had told me about how floor traders sometimes used OEX options and SPX futures to hedge against each other. Hmm. I went hunting.

I found a blog that mentioned that same concern about floor traders hedging futures risk with OEX options and vice versa in an arbitrage trade. I also found an article by Mark Wolfinger on Investopedia warning about the possibility of early exercise on American-style OEX options that still had extrinsic value. It was Wolfinger who offered an explanation that seemed plausible, although the instance he described was perhaps far-fetched and downright unlikely.

Suppose, Wolfinger theorized, that someone had a credit spread in which they'd sold a higher-strike put and bought a lower-strike one. This would make up what we know as a bull put credit spread. Suppose that prices had dropped way below both strikes, so that the sold put was $40.00 in the money, its intrinsic value, and it also still had some extrinsic value due to the time before it expired. (Yikes, I thought. Hadn't this supposed trader ever heard of trade management?)

Next suppose that, just after stocks had stopped trading one day but while index options were still trading, some beneficial news that was sure to send the markets soaring the next morning was announced. Whoever held that long put that had been $40 in the money at the close, the one our trader had sold as part of a credit spread, might suspect that when the markets opened up the next day, that put wasn't going to be worth nearly as much as it had been worth at the close. That person elects to exercise that option.

Remember that option's value would be determined based on that day's settlement value. That settlement value would be based on the before-the-news closing values of each separate component of the OEX. For argument's sake, let's suppose that the OEX's settlement value still kept that OEX put $40.00 in the money. The person or institution that exercised that call would be due $40.00 per contract x the 100 multiplier.

The next morning, the trader who'd held that bull put credit spread might have been momentarily relieved to find that the futures were way higher but would find his relief short lived. When he opened his account, that trader would find that the short put had been exercised. He would have to pay $40.00 per contract x the 100 multiplier due to the assignment. The long put that was part of the bull put credit spread would be the only position left out of that credit spread. However, if the live market action followed the soaring-higher futures' action, that long put position that remained as the only part of his credit spread would be worth far less than it had been previous day because the markets had indeed soared. Therefore, that hapless bull put credit spread trader would be facing a loss that was perhaps far worse than the maximum loss that the trader had thought possible.

For example, imagine that the two strikes had been only 10 points apart. That trader would then have believed that he had a risk that was defined by the following formula: ($10.00 x number of contracts x 100 multiplier) - the credit he took in when he established the trade + commissions and fees. He would never have figured a loss at nearly $40.00 per contract x the multiplier - credit received + commissions and fees.

Yikes. I spent a day questioning everyone I knew who had once been in the pits, wanting to know if Wolfinger's scenario was either possible or likely. Possible? Yes, at least theoretically, they concluded. Likely? Not very, was the conclusion. In fact, the risk was infinitesimal. A prediction of an extreme reversal in the market at the next day's open and a narrow time frame (after the individual components of the OEX had stopped trading but before options did) would have to combine in just the right way to make this kind of exercise even remotely possible.

Still. I'm thinking I'll try the XEO again for my iron butterflies. As long as the fills aren't too difficult--and they weren't in my previous years of trading them, including for iron butterflies--I'll just remove that little risk, no matter how remote it might be. The OEX is fine for my far-out-of-the-money options.