Index Exercise Essentials

American Style Cash Settled (The OEX)

The OEX refers to the index of the S&P 100. Its options trade on the floor of the Chicago Board Options Exchange. The index is unique in that as is the case with equity options, the options are settled american style, meaning that they are subject to early exercise. However, unlike with equity options, OEX options are cash settled. This gives a trader additional nuances and opportunities to consider.

Expiration of OEX options takes place on the Saturday following the third Friday of each month. However, the last day of trading will usually be that third Friday. Settlement also occurs on the third Friday for any options that were not exercised early. For options that are exercised early, settlement occurs at the close of the day of exercise.

The important thing to keep in mind with cash settled options is that unlike in the case of equities which settle to stock, when you settle an option for cash, you no longer have a position. Instead, if you exercise an option that is in the money, you receive the difference between the stock price and the strike price. If you are short an option and it expires in the money, assuming that the other side exercises the option, you will have to pay the difference between the stock price and the strike price. If an option expires out of the money and you do not exercise it (as there usually is not a good reason to do so), no money changes hands.

More specifically, let’s take a look at the following option chain from expiration Friday. The OEX closed at $699.80 and the front month option chain looks as follows:

In order to get a feel for how cash settlement works, we will look at several scenarios.

First Scenario: You are long one contract of the OEX 690 call

If you were long the OEX front month 690 call, then with the OEX at $699.80, your 690 call would be in the money by $9.80 and it would be automatically exercised. Therefore, after cash settled exercise took place, you would see $980 added to your account ($9.80 per contract X 100 multiplier).

Second Scenario: You are short one contract of the OEX 690 call

If you were instead short the OEX front month 690 call, then your position would once again be automatically exercised. Once the cash settlement took place, your account would be reduced by $980, that being the amount that your short option was in the money.

Third Scenario: You are long one contract of the OEX 700 call

If you were short one contract of the OEX front month 700 call with the OEX at $699.80, then your call option would be out of the money by 20 cents. In this case, your option would automatically expire worthless.

• Special Note: If you were short the 700 call with the index closing at $699.80, you may be worried about getting assigned on your short option and having the index move. This is not a concern in the OEX as the settlement value of the index is defined by Friday’s close. Therefore, wherever the index closes for the day, that’s the price at which the cash settlement is determined. Exercise and assignment then happen automatically as there is no advantage to exercising an option that was out of the money according to the close of the day on expiration Friday.

• As a second note, keep in mind that things may be different on any day prior to expiration Friday. Since the OEX follows the rules of American exercise, traders do have a choice of which options to exercise on any day prior to expiration Friday.

European Style Cash Settled Part 1 (The XEO)

Expiration of XEO options takes place on the Saturday following the third Friday of each month. However, the last day of trading will usually be that third Friday. Settlement also occurs on the third Friday. Unlike in the case of the OEX, XEO options follow European exercise rules meaning that there is no early exercise. Therefore, the XEO procedures are identical in nature to those of the OEX except that there are no special early exercise nuances.

European Style Cash Settled Part 2 (The SPX, NDX, and DJX)

Expiration of SPX and NDX options takes place on the Saturday following the third Friday of each month. However, the settlement day will usually be the Thursday prior to expiration. This is the last real trading day for the options. However, unlike OEX and XEO options, settlement does not occur on Thursday’s close. It actually does not take place until Friday morning. The calculated settlement price for the SPX, NDX, and DJX indexes are called the SET, NDS, and DJS respectively. Since all three settlement values work in similar fashion, we will use the SPX and the SET as our example of choice. It is calculated by using the opening prices of all of the stocks in the respective index. In some cases, especially in the case of the SPX where we have to wait for 500 stocks to open, there may be times when the SET value comes late in the day. In other cases, a stock in the index may not open due to special news or circumstances. In that case, the value that will be used in the SET calculation will be the last reported sales price for that stock.

A closer look shows that there may be times when holding SPX, NDX, or DJX options overnight may represent significant risks to a trader. In fact, the SET may actually be a price that never actually traded! In that case, traders may end up with options that would have expired worthless on Thursday’s close, but that based on Friday’s open are now worth something. Conversely, a trader may have exercised options that were expected to be in the money on Thursday’s close but that due to strong movement either way, were worthless based on the SET value from Friday’s open. In this case, a trader would also lose money on his cash-settled position. Depending on how many options a trader was long or short, this could represent a large financial loss to a position. Therefore, the only failsafe method for avoiding SET risk is to close out your positions prior to the close of the last Thursday before expiration.

More specifically, let’s take a look at the following option chain from expiration Thursday. The SPX closed at $1512.75 and the front month option chain looks as follows:

Notice that even though we are looking at the option prices on Thursday’s close, the options have not settled to real value. On Friday morning, there will be a new front month and the options above will no longer be available for trading. Therefore, Thursday is the last possible day to trade these options. Still, some time value remains. The reason is that while the OEX and XEO options settle on Thursday’s close, SPX options settle to a yet-to-be disclosed price – the SET value.

Depending on where the stocks that make up the SPX open on Friday morning, your options will in all likelihood settle at a different value than that at which they closed on Thursday afternoon. Let’s look at several scenarios to show how a Friday settlement may affect your profitability. We will take on the assumption above that the SPX closed at $1512.75 on Thursday afternoon.

First Scenario: You are long one contract of the SPX 1510 call and the SET value released Friday morning is unchanged from Thursday’s close.

In this case, your long call will have $2.75 of real value. Therefore, upon automatic exercise and settlement, you will receive a deposit of $275 to your account. Looking at the values of the SPX on Thursday’s close, you would have been better off closing out your position by selling your call option on the bid at $5.10. However, hindsight is always 20/20 and we had no way of knowing what would actually happen on Friday.

Second Scenario: You are long one contract of the SPX 1510 call and the SET value released Friday morning is $1520.

In this case, your long call will have $10.00 of real value. Therefore, upon automatic exercise and settlement, you will receive a deposit of $1000 to your account. Looking at the values of the SPX on Thursday’s close, closing out your position by selling your call option on the bid at $5.10 would have yielded less money than waiting for Friday’s SET value to come out. Again, hindsight is always 20/20 and we had no way of knowing what would actually happen on Friday.

Third Scenario: You are long one contract of the SPX 1510 call and the SET value released Friday morning is $1500.

OK, so you go home feeling pretty good about yourself as the 1510 call that you were long went out with real value on Thursday. In fact, if the SET value was a few dollars higher Friday morning, you would make even more money. However, the stocks in the SPX all opened lower on the day and as a result the SET value was $10 below your strike. This means that your 1510 calls remained unexercised and you did not make any money on the position. In hindsight, you would have been better off closing out the position on Thursday afternoon.

Fourth Scenario: You are short one contract of the SPX 1520 call and the SET value released Friday morning is unchanged from Thursday’s close.

With the SET value equaling the cash value of Thursday’s close, your short 1520 call expires worthless and no money changes hands at expiration. In this scenario, you are happy.

Fifth Scenario: You are short one contract of the SPX 1520 call and the SET value released Friday morning is $1530.

In this scenario, your short option was over $7 out-of-the-money on Thursday’s close. You felt pretty good about holding this position overnight. However, all of the stocks in the SPX opened higher on Friday. This led to a SET value of $1530. This placed your short 1520 call in-the-money by $10.00 meaning that on Friday, your account would lose $1000. This scenario can come as a rude awakening to many traders. To cause further confusion, due to the way the SET is calculated and due to the way that the SPX cash is calculated, a trader may end up in a situation where the SET value is considerably higher than any value that the cash traded for on Friday.

Therefore, it is important for index traders to fully understand how settlement and automatic exercise procedures work. We have seen many cases of traders suffering unexplainable losses in iron condor positions on indexes. An understanding of the settlement procedures for the index that you trade can help clear up many surprises.