Index stock options create investment opportunities for investors who wish to take advantage of market moves, as well as protect existing holdings. Offering known risk, the premium set by a long index option ensures the investor will not incur losses exceeding the purchase price of the index option. Investors can also take short positions with index stock options, but with the potential for unlimited loss in many cases. Additionally, an index credit spread stock options position, short an index option and long an index option with the same expiration month, gives investors an opportunity to pursue leveraged investments without paying interest fees for margin as with other leveraged strategies. However, the risks associated with credit spreads on indexes must be carefully considered.
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Broker Exercise Procedure
Index stock options attach strict details when purchased, particularly the expiration date, and more specifically an hourly deadline to exercise the stock options. When purchased by the investor, the stock options expire at this set time and date, unless exercised, or sold prior to expiration. Due to the fact that different deadlines can be established and set instructions are defined for the expiration of the index option on the last day of trading, investors should become familiar with their broker’s exercise procedures. Broker stock options exercise procedures can vary from broker to broker and missteps related to stock options exercise can be very costly.
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American vs. European
It should be noted that stock options on certain indices are classified by either the American option style or the European option style. In the case of American-style stock options, the investor maintains control over the right to exercise, or sell, the stock options at any time before or at the specified time on its expiration date. Failure to exercise an American-style stock option will result in the expiration of the option as a financial instrument, basically rendering it worthless as it ceases to exist.European
European style stock options specify a strict time period for exercising the stock options prior to expiration. Within the assortment of different European style classes, the period varies or in some cases does not allow the exercise of the stock options prior to expiration.
Index Option Settlement
Details of an index option‘s sale and expiration can be determined in a variety of ways, but the two most common are an AM Settlement and a PM Settlement. Like the hours of the day, these exercise settlements reflect the opening numbers and closing values of the day’s trading. To avoid surprises on the Friday of stock options expiration, the issues associated with the individual settlement styles require careful handling.
A PM Exercise Settlement establishes its value at the close of the market, when the last reported prices for the individual stock components are calculated to determine the index’s value. Most ETFs are PM Settlement, including the most favored QQQQ, SPY, IWM and DIA. A well-known index with PM settlement is the S&P100 Index (OEX).
AM Exercise Settlement is established by calculating the opening prices of the individual component stocks of an index and thus the index option is exercised or sold based on that value. The S&P 500 Index (SPX) covering a broad range of industries is a commonly known AM Exercise Settlement index option.
AM Settlement Delayed
AM settlements are susceptible to certain glitches in the system of reporting, as the opening value of the index is the respective opening values of all of the stocks of the index. But sometimes a stock may not actually trade for several hours or may not trade at all on a given day, delaying the calculation of the final settlement value.
AM Settlement Potential Gottcha
With an AM settlement, index options stop trading the day before expiration. Most often the investor can sleep soundly as large moves in the index seldom occur between Thursday afternoon and Friday morning. Unfortunately, should an adverse change in the value of an index with AM settlement occur between Thursday’s close and Friday’s open, an investor could experience a very disappointing loss after a gain appeared certain on Thursday afternoon. Additionally, since index options stop trading for AM settled indexes at Thursday’s market close, an index option investor basically becomes a captive to the index option with AM settlement after the market closes on Thursday. There’s no way for an investor to exit an index option with AM settlement after Thursday’s market close, yet the underlying index is subject to change. A market-moving event occurring after Thursday’s market close can significantly move an index on Friday causing potential heartburn for index option investors.
AM Settlement Risks with Index Options
Investors trading index option credit spreads should be very careful in trading index options with AM settlement as sudden moves between Thursday’s close and Friday’s open can turn a sure gain on Thursday into a very big loss on Friday. An example of an index AM settlement causing heartburn for index option credit spreads for the Russell 2000 Index (RUT) occurred in August of 2008.
AM Settlement Example with RUT
The RUT closed on Thursday, August 14 at 754.38 and according to the stock chart/ticker tape the RUT had an opening price of 759.26 on Friday, August 15. Since the RUT is AM settled, it would appear that any bear-call credit spreads position with a short call option strike price greater than 759.26 would be 100% profitable, i.e. 760, 765, 770, etc. However, the final settlement value for RUT was determined to be 765.07 – almost 6 points higher than indicated by the opening stock chart/ticker tape value. With the 765.07 settlement value for RUT, all of the bear-call credit spreads positions with a long call strike price of 760 are now much less profitable than previously thought. As an extreme example, the bear-call credit spreads position for the strike price combination of the 760/770 went from profitable on Thursday afternoon to a loss of approximately 50% on Friday.
What to Do About AM Settlement and Index Credit Spreads
The best answer as to what to do about AM settlement and index credit spreads is to either avoid index options with AM settlement or to simply exit the position on Thursday if the short option strike price is “close” to the value of the index. An investor deciding to exit a “close” position early, must decide on a value for when the index is “close” to the strike of the short index option. One way to determine “close” is to evaluate historical movements of the AM settled index between Thursday’s close and Friday’s settlement value.
Historical Analysis of AM Settlement
Using PowerOptions powerful historical back testing took, a historical analysis from May 2006 to August 2008 of Thursday’s close values versus the settlement prices for AM settled indexes revealed some surprising results. Tables of the maximum percent changes, increase and decrease, between Thursday’s close and Friday settlement for several AM settled indexes are shown below.
| Maximum Increase Change for AM Settled Indexes
Thursday Close to Friday Settle
May 2006 to August 2008
& Month/Year Occurred
|SPX||2.8% Aug 07||0.6%|
|DJX||2.4% Aug 07||0.6%|
|RUT||4.4% Aug 07||1.1%|
|NDX||2.8% Apr 08||0.8%|
| Maximum Decrease Change for AM Settled Indexes
Thursday Close to Friday Settle
May 2006 to August 2008
& Month/Year Occurred
|SPX||-0.6% Oct 07||-0.3%|
|DJX||-0.9% Oct 07||-0.2%|
|RUT||-0.9% Mar 07||-0.3%|
|NDX||-1.5% Jul 08||-0.5%|
Even though the average index value changes from Thursday’s market close to Friday’s settlement are approximately 1% or less, there are some very significant outlier cases where the change in the value of the index was very significant. For example, the largest percentage movement as illustrated in the tables from Thursday close to Friday settlement during the time period was the RUT index. The RUT index experienced a very large +4.4% movement from Thursday’s market close to Friday’s settlement in August of 2007. The next largest movements of the RUT were much smaller and were experienced in March of 2008 at +2.1% and June of 2007 at +2.0%.
Investing in credit spreads for index options with AM settlement must be carefully considered. In general, if an index value is within 2% to 3% of the short strike of an index option credit spread on the Thursday before Friday stock options expiration, an investor should carefully consider exiting the position early on Thursday. Even if the value of the index is within 4% of the short strike of the index options credit spread on Thursday before Friday stock options expiration, an investor should be a little nervous. PowerOptionsApplied uses index options for its Iron Condor related products. An Iron Condor position is a combination of a bull-put credit spread and a bear-call credit spread on the same underlying. For example, to prevent issues related to AM settlement, PowerOptionsApplied selects initial Iron Condor positions with a wide distance between the index value and the short index option‘s strike price. PowerOptionsApplied also uses generous stop-loss values for exiting Iron Condor positions. Additionally, PowerOptionsApplied carefully monitors its AM settled index Iron Condor positions for exiting early on the Thursday before stock option expiration on Friday if the value of the underlying index is close to either of the short index option strike prices.
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[tags] American option, European option, QQQQ, SPY, IWM, DIA, OEX, RUT, bear-call credit spreads, covered call investment strategy, investment strategy, iron condor, option investors, poweroptions, stock option trading, stock options [/tags]