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Index 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 ensures the investor will not incur losses exceeding the purchase price of the . Investors can also take short positions with index , but with the potential for unlimited loss in many cases. Additionally, an index credit spread position, short an and long an 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 on indexes must be carefully considered.
Broker Exercise Procedure
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Index attach strict details when purchased, particularly the expiration date, and more specifically an hourly deadline to exercise the . When purchased by the investor, the 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 on the last day of trading, investors should become familiar with their broker's exercise procedures. Broker exercise procedures can vary from broker to broker and missteps related to exercise can be very costly.
American vs. European
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It should be noted that on certain indices are classified by either the American option style or the European option style. In the case of American-style , the investor maintains control over the right to exercise, or sell, the 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 specify a strict time period for exercising the 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 prior to expiration.
Index Option Settlement
Details of an '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 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 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 .
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, s 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 [no rx aciphex
] s stop trading for AM settled indexes at Thursday's market close, an investor basically becomes a captive to no rx aciphex
the with AM settlement after the market closes on Thursday. There's no way for an investor to exit an 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 .
AM Settlement Risks with Index Options
Investors trading should be very careful in trading s 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 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 position with a short 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 positions with a long call strike price of 760 are now much less profitable than previously thought. As an extreme example, the 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 is to either avoid s with AM settlement or to simply exit the position on Thursday if the 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 . No rx aciphex
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 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
||2. 8% Aug 07
||2. 4% Aug 07
||4. 4% Aug 07
||2. 8% Apr 08
| Maximum Decrease Change for AM Settled Indexes
Thursday Close to Friday Settle
May 2006 to August 2008
& Month/Year Occurred
||-0. 6% Oct 07
||-0. 9% Oct 07
||-0. 9% Mar 07
||-1. 5% Jul 08
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 for s with AM settlement must be carefully considered. In general, if an index value is within 2% to 3% of the short strike of an credit spread on the Thursday before Friday 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 s credit spread on Thursday before Friday expiration, an investor should be a little nervous. uses s for its related products. An 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, selects initial positions with a wide distance between the index value and the short 's strike price. also uses generous stop-loss values for exiting positions. Additionally, carefully monitors its AM settled index 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 strike prices.
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