Options settlement is unfortunately an often overlooked aspect of index option trading, but one that can give you a nasty shock if you hold your positions to expiration (which, by the way, you shouldn’t).
With single equity options, it’s pretty easy to know if your options end up in-the-money on options settlement day. The options settlement value used is simply the closing value of the stock at the end of the day. But do you know what the options settlement value of the RUT (Russell 2000) is? Somewhat surprisingly, it’s not the RUT.
Options Settlement Price is Determined on Friday Morning
Monthly options on the RUT, SPX, and DJX stop trading on the Thursday before expiration. However, the actual settlement value is not determined until the next day. According to the CBOE:
The settlement value is calculated using the opening sales price in the primary market of each component security on the last business day (usually a Friday) before the expiration date
This means that the options settlement value is not the opening value of the index itself, but rather the value of the index as calculated from the opening prices of all the constituent companies of the index. Now this often isn’t a big deal for the SPX or the DJX. These indices are composed of big companies that mostly start being traded exactly at market open. However, it is a big deal for the RUT – because it is composed of fairly small companies, not all the constituents in the Russell 2000 start trading as soon as the market opens.
Imagine the RUT opens sharply down, and 900 companies print their opening values significantly lower than where they closed the day before. However, within a few minutes the market rallies strongly and the other 1100 components of the index finally start being traded. These companies are printing their opening price much higher than their previous closing price.
If we looked at a chart of the RUT, it would look like it opened down strongly. However, because of the odd way the it is calculated, the options settlement value used for options is actually higher than the opening value of the RUT. In fact, depending on how the index moves, you can get an options settlement value that is higher than anything the actual index reached during the day’s trading. Naturally, this can be a pretty big shock if you are short a call option that you thought was safely out of the money. Unfortunately, the options settlement value for the RUT often isn’t published until late on Friday afternoon (on the options settlement page of the CBOE website), so you could be in for a nervous wait.
Here’s a representative year (2007) for the opening prices of the RUT on expiration Friday alongside the actual options settlement values for each month:
What you see is that most of the time, the opening price of the RUT is the same (or near) the settlement value. However, a few times of year (in this case, April, June, and August, which I’ve bolded), you could end up getting screwed. The most bizarre example of this was in August. If you were short an 800 call, you would think you were fine on Thursday afternoon and Friday morning. However, somehow the settlement value ended up at over 802 despite the index actually opening at 784.
Now, while I’ve mentioned above that this isn’t as big a deal for the SPX and DJX, it still can happen, and it can happen regularly.
So what can you do to protect yourself? Well, let’s be clear about one thing – you probably shouldn’t be holding these positions in the first place. By trading close-to-the-money options you are exposing yourself to huge gamma risk (take a look at our options delta primer for a quick review). For most people, taking this risk is simply not worth the few pennies you’ll make. I like a stress free existence, and this means avoiding near-expiration options.