Trading European Index Options
Know What You Are Trading
index options are among the most actively traded options: SPX (options on the S&P 500 Index, RUT (Russell 2000), NDX (NASDAQ 100) primarily because it is more comfortable for individual investors to invest in the "whole stock market" -- or a segment of the market -- rather than an individual stock.
Traders who use index options must exercise due diligence because these puppies are different from ordinary American-style options.
All options on stocks or ETFs (exchange traded funds) are American style options. If you are not aware of those differences, that can be harmful to your financial health.
Some European options cease trading at the close of business on Thursday, one day before the index settlement price is determined. Those are referred to as AM settled options. Other index options do trade on expiration Friday and the settlement price is determined by the closing price of the specific index. These options are referred to as PM settled.
The problem is that there are no warnings for novice traders. When you buy or sell any option, it is your responsibility to know what you are trading. The option symbol provides some help, but the inexperienced trader can be confused easily.
If you tend to exit positions prior to expiration (I recommend doing that), then you may not believe it is important to know difference between AM- and PM-settled options.
However, it does matter, primarily reason because
- That extra day of trading affects the market price of the option
- When a European-style index option does not trade on expiration Friday, you must exit prior to the close of business on Thursday. If you neglect to do that, there will be no opportunity to close the position Friday morning, and no way to avoid the significant risk associated with determining the settlement price.
AM vs. PM settled options
RUT and NDX option traders are spared any confusion because all options are AM settled. Thus:
- The options stop trading at the market close on Thursday, prior to expiration Friday.
- The settlement price is calculated from the opening prices of each of the stocks in the index. For details on how this works, read the post on settlement prices.
The original SPX options expired only on the 3rd Friday of each month, making (almost) everything cozy. Today, not only is there a set of options that expires every Friday (SPXW), but there are morning and after-the-close expiration times.
The final settlement price (official closing index price) for these 3rd Friday options is calculated by using the opening price for each individual stock in the index. The process is identical with that used for RUT and NDX options and sometimes leaves less-experienced traders angry and confused when the settlement price differs from expectations.
In 2011, PM-settled, electronically-traded S&P 500 Index options with the ticker "SPXpm" began trading. Both SPXPM and SPXW 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 not the same as "original SPX, 3rd Friday options" because SPXpm options trade one day longer (expiration Friday). SPXW options are issued to expire Friday, on a weekly basis -- but never on the 3rd Friday. That 3rd Friday is reserved for "original" SPX options.
SPX EOM (end of the month) options were added to the mix in mid-2014. These options trade on expiration day, are PM-settled and expire on the last business day of the specified calendar month. These options also trade under the symbol SPXW.
If you find this to be confusing, then it may be best to avoid trading SPX options -- until you have a clear understanding of the differences.