Settlement Prices Can Be Unsettling
Alert: Understanding European Settlement
Using index options -- instead of individual stock options -- provides some advantages. Traders who adopt income-generating strategies (i.e., selling option premium) depend on price stability to generate profits. These strategies may provide the trader with reduced returns, when compared with the stock market as a whole. That is to be expected because no strategy can beat the averages every time.
For example, an unexpected news announcement for one specific stock may have a drastic effect on the price of that one stock, but it takes a big event to result in a similar percentage price change in an index. Such a price change often results in a huge loss for the trader who had sold naked (unhedged) options. It is usually more efficient to trade index options when your trade objective is collecting time decay, or positive Theta.
NOTE: "Selling option premium" refers to strategies that earn money from the passage of time. These methods have positive Theta and negative Gamma and do not depend on rising prices to generate profits.
American vs. European Options. Settlement Price
The settlement price is the official expiration closing price for the underlying asset. Out-of-the-money and at-the-money options expire with no value and are worthless. In-the-money options are worth their .
To trade index options, you truly must understand the process. Many a newcomer to index options has incurred a substantial loss because of his/her failure to understand the basic information. And I have some sympathy because the determination of the settlement price for AM-settled options is non-intuitive.
- When a stock closes for trading at the end of business on expiration Friday, the last trade determines the settlement price. That is not true for those European-style options that expire in the morning (RUT, NDX, and 3rd-Friday SPX).
To complicate matters further, there are two distinct methods for calculating the settlement price, depending on the characteristics of the option.
- The first SPX options expired only on the 3rd Friday of each month. Today, other expiration dates exist (Weeklys and end-of-month expiration). Settlement prices for RUT, NDX and the "original 3rd-Friday SPX options" are calculated by using the opening stock price for each stock in the index. These options stop trading when the market closes on Thursday, one day prior to expiration Friday.
Thus, any trader who does not close all positions before they stop trading on Thursday incurs overnight risk. If the market gaps higher or lower on Friday, then the settlement price will be far different from the closing price on Thursday. The options do not trade on Friday and you can do nothing to mitigate an unfavorable market opening. If you fail to cover a short options position (either naked short or part of a spread), then your position can settle at a very disadvantage price. I recommend that premium sellers never hold these AM-settled options into expiration Friday.
- SPXPM and SPXW (weekly and end of month) options trade on expiration Friday. The exercise-settlement value is the official closing price of the S&P 500 Index as reported by Standard & Poor's on expiration Friday. NOTE: SPXPM options are similar to "original SPX options" but SPXPM options trade for one entire trading day longer (expiration Friday). SPXW options are issued to expire on a weekly or monthly basis -- but never on the 3rd Friday. SPX EOM (end of month) options are PM-settled and expire on the last business day of the specified calendar month.
The original index options, the 3rd-Friday SPX ,along with NDX and RUT options, were always "AM settled" and that nomenclature was continue.
Later, "PM settled" options were introduced and the term refers to options whose settlement price is the final price of the day for the specific index.
- The settlement price for "AM settled" options depended on calculating the index price based on the opening price of each of the individual stocks that comprised the index. It is not a real-world price.
- The settlement price for "PM settled" options is the true closing price of the index, as reported by Standard & Poor’s.
Note the subtle difference. PM settled options used the index value, as it normally calculated. That value depends on the most recent price at which each of the individual stocks traded. In other words, almost all prices are very recent. However, or stocks that did not trade recently, the last price is used.
However, for AM settled index calculations, only one price matters -- the opening price. Most of the time, the settlement price (published at 1:00 PM ET for SPX and after the market closes for NDX and RUT) offers no surprises. However, when the market gaped at the opening, the situation was very different and often produced an "unbelievable" value for the uninformed.
Be Aware of this Possibility
The following scenario describes how "surprises" occur:
- As the US market is ready to open (9:30 am ET), large quantities of stock are for sale because some bad news is in the air. It could have been political upheaval, a surprising earnings report from a major company, or simply the result of markets being substantially lower in Asia and Europe. When stock is for sale, prices open lower.
- Five-minutes after the opening bell, many stocks in the index will not yet have opened for trading, due to the imbalance of sell orders. Thus, when Standard & Poor's publishes the "current" SPX value, it includes the previous day's closing prices for each stock that has not yet opened. Thus, SPX will appear to have "opened" with only a modest decline. The problem is that this opening SPX price has nothing to do with the final settlement price. That price has yet to be determined, and cannot be calculated until all stocks open.
- When there is a sell imbalance (it could also be a buy imbalance), buyers must be found to absorb all the stock for sale because it is necessary to agree on a single price that reflects the current situation. Until that price is discovered, the imbalance remains, and the stock does not trade.
- Consider what happens when that sell imbalance for individual stocks remains, but the market (for stocks that have already begun trading) strengthens. Sellers disappear as more buyers arrive on the scene. The sellers are now outnumbered by buyers and stock prices gradually rise. This relieves some selling pressure on the stocks that have not yet opened and gradually these stocks open -- but at prices that are still significantly lower than the previous day's close.
- By the time that all (or virtually all) 500 SPX stocks have traded, the stock market has completed its rally and the last published SPX price may (for example) be two points higher. The remainder of the trading day is uneventful and the lowest published SPX price was down 7 points. Traders who were short slightly out-of-the-money puts feel relieved because they "know" that those puts did not move into the money and did not jump in value.
- It is important to understand that the settlement price ignores the rally. The settlement price depends on the initial trade of the day for each stock. Some trades occurred during the worst of the decline, but even later trades occurred at prices that were lower than the previous close. Translation: even with the rally, newly-opened stocks contribute to a further decline in SET (the SPX settlement value).
- When the smoke clears and SET is published, those put sellers suffer anguish when SET is announced as 20-points lower than the previous day's close. They scream "conspiracy" and believe the option traders cheated them. But the truth is that the traders had no idea what the rules were, and have no one but themselves to blame.
It is fairly easy to prevent this unhappy scenario to hurt your account value. Be aware of the details of options that you trade -- and know how to avoid being at risk. To avoid AM-settlement risk, just exit positions on the last day that the options trade. There is no good reason to be holding index options that will expire on the opening of trading.