A very thorough understanding of OEX american exercise options is typically needed before a trader can reasonably expect to navigate an exercise scenario from the side of a long option, let alone if he is short options and needing to protect himself. This easy-to-understand material is a Reader’s Digest version of what occurs during the OEX exercise process.
A. Why should you early exercise the OEX and not european exercise the XEO?
Many brokers will attempt to sell you on the fact that the XEO is a “better product to trade,” and may even stretch the truth (euphemistically speaking) as far as to declare “the XEO trades more volume” or “is more liquid.” The truth is that since its inception, the OEX index has always traded higher volumes than the non-early exercise XEO. There is no logical reason for this, other than the fact that many do not know of its existence, and that it was not marketed by the CBOE (Chicago Board Options Exchange) with any exceptional effort.
Whatever the real reason for the XEO’s popularity may be, it still does not provide any reason to trade the OEX as opposed to the XEO. The tighter bid-ask spreads and deeper liquidity make the OEX a far superior product, even with the risk of a very vague and little understood exercise feature. Whatever the quantified dollar value of the risk associated with the OEX early exercise, it is still likely to be well worth the effort in savings when compared to the pitfalls of the XEO.
B. What affords the early exercise opportunity?
At approximately 4 p.m. Eastern Standard Time (EST), the stocks on the New York Stock Exchange close for trading. Since the OEX index is comprised of the largest 100 stocks, its value is mostly derived from the prices of the NYSE stocks. The cash markets and the index cash close at 4 p.m. EST as well, but the futures market remains open for an additional 15 minutes (until 4:15 p.m. EST).
4 p.m. to 4:15 p.m. EST:
It is this 15-minute timespan that creates your opportunity. Oftentimes a company’s daily earnings are announced immediately following the close of the market. Economic reports, which have the ability to affect the next day’s opening, the opening of foreign markets, etc., can force the markets to move between 4 p.m. and 4:15 p.m. EST. When the cash is frozen and the options can be exercised at their closing prices while the market is still moving, opportunity arrives.
How It Works: Part I
Suppose that regardless of where a stock moves, you can buy or sell it at a certain price. How much would you pay for that right? You already know the answer to this question, as this is the pricing of an option. Yet what if the option could only be exercised at an advantage for a span of 15 minutes out of the entire day? This would presumably reduce the stock’s value, wouldn’t it? Now consider you have been given the opportunity to acquire this right/benefit for free (or for a cost that is virtually free)? Wouldn’t that purchase be worth the cost, as such a deal is not available anywhere else in the markets? That “deal” is the OEX early exercise when you are long options.
How It Works: Part II
Rules
The following definitions typically hold true for exercises:
CALL EXERCISE – The market sells off after the cash close (4 p.m. EST).
PUT EXERCISE – The market runs higher after the cash close (4 p.m. EST).
A more precise way of defining these terms, appropriate for the more advanced exerciser, is as follows:
CALL EXERCISE – Synthetic stock is trading below the cash price.
PUT EXERCISE – Synthetic stock is trading above the cash price.
Reason for the rules
Logically speaking, this seems counterintuitive to most people until they think through the process carefully and thoroughly. Let’s examine each of the terms individually. If you still don’t feel as though you have a complete grasp on the material, the mathematical explanations which follow should solidify the material for you.
Explanations
Call Exercise
After cash closes and the market sells off, it becomes a call exercise because the exercise of a call in this position will rid your overall position of positive deltas. Typically any call being exercised is so deep ITM that the calls will be close to 100 delta calls, which when taken out of position leave the pre-exercise position short an abundance of deltas. In order to return to a delta neutral position, one has to buy deltas – usually in the form of long synthetic stock (a long call and a short put). This person will be buying deltas via synthetic stock at a lower price than the long deltas he closed out in the exercise, thus a locked in profit is made.
Put Exercise
After cash closes and the market runs higher, exercising a deep ITM put will result in one’s position growing much longer in deltas. Remember, puts have a short delta and getting rid of them (by selling them out or exercising them) secures the position longer in deltas. In order to reestablish a position that is delta neutral, one has to sell deltas. Since the OEX does not have an underlying that can be traded, the easiest way to sell deltas is by selling synthetic stock (sell a call and buy a put). The trader will be selling deltas at a higher price via synthetic stock than the short deltas he closed out in the exercise.
If these explanations have confused you, or if you feel they make sense but you are still not completely confident in their implications, please do not become discouraged. For many, many years the traders who made livings by standing in the OEX pit were often confused on the subject of the same process. I doubt it was because of the complexity of the process as much as no one would explain how worked to their competition and none bothered wasting their time figuring it out. Another factor which contributed to the delayed popularity of this product is that during its early years, there was such a large amount of money being made by scalping options that learning to trade something esoteric seemed like a waste of time to many traders. Since the early exercise of options only occurs a few days out of each month, the thicker of the traders who did grasp the concept quickly forgot it by the time the next month came due to lack of repetition. Again, be patient and view the following mathematical explanations. They should make more sense now that you are familiar with the fundamentals and hopefully, this will help to cement the concepts in your minds more firmly.
How It Works: Part III (A Mathematical Explanation)
Step #1 – Wait for Cash to Close
Step #2 – After Cash Closes, Look at the Synthetic
Step #3 – Do Nothing Until a Divergence
Step #4 – Call or Put Exercise?
CALL EXERCISE – Synthetic stock is trading below the cash price.
PUT EXERCISE – Synthetic stock is trading above the cash price.
Step #5 – Start Trading Synthetic Stock in Anticipation of Exercise
Step #6 – One Exercised Option Usually Equates to One Synthetic to Trade
Step #7 – Make Sure All Combos are Bought/Sold
Step #8 – Only Exercise What Was Hedged
Step #9 – Contact Your Broker
Step #10 – Keep your eye on the synthetic short option that is in position or was created
Step #11 – Double-Check Your Math
Step #12 – DOUBLE-Check Steps 1 THROUGH 12