A lot of investors like to incorporate index options into their strategies because they are more stable and easier to predict. These are usually better for using neutral strategies like iron condors. An index option is simply an option based on one of the major indexes such as: S&P 500, Russell 2000, Nasdaq, etc… Most investors also know that index options are AM settled. Typical option expiration occurs at the close on the 3rd Friday of each month. However, index options expire that Friday morning giving investors one less day to worry about.
Now AM settlement might seem like a good idea but it carries with it one major drawback, which is SET. SET is the settlement value given to the indexes on Friday morning.
Let’s look at an example:
October 21, 2011 was option expiration
The day before, that Thursday the SPX (S&P 500) closed at 1215
Friday Morning the SPX opened at 1215
SET Value is 1228 a 1.06% difference.
Why does this matter? Let’s say you are short the 1225 calls and you see the market close at 1215 on Thursday. You can now go to bed happy because your options will expire worthless and you will collect a nice premium. Unfortunately when the market opens that Friday the CBOE (Chicago Board of Option Exchange) calculates all the opening prices for every component in that index and uses that as the settlement value. Some stocks gap higher, gap lower, or don’t even trade in the morning but all of these values are taken into account. Through this process we can get a big swing in SET value over the close/open price of that index. The real crummy part is that your options stop trading Thursday at the close, and if you are still holding then you are at the mercy of SET. So now those 1225 calls you had a profit on are now showing a loss.
You should not hold index options into the close on Thursday if they are around the closing value. Go ahead and close it out early to guarantee you get the price you want. Don’t get caught looking at a profit on Thursday only to have it turn to a loss on Friday morning.
As of this writing the CBOE has now introduced SPX PM options. These are traded electronically and not in a pit like the AM options. This will allow you to get better/easier fills at a smaller spread. If they are successfully, which we think they will be, then this will be a good alternative to AM settled options. Upon their success we could see more index options coming out with PM settlement.
You can check the settlement values on options here: http://www.cboe.com/data/Settlement.aspx
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