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Settlement Prices Can Be Unsettling


Settlement Prices Can Be Unsettling

Using index options instead of individual stock options offers advantages for traders employing income-generating strategies like selling option premium. These methods rely on price stability to make profits, often resulting in slightly lower returns compared to the overall stock market. This is typical as no strategy consistently outperforms the market.

For instance, unexpected news impacting a single stock can drastically alter its price, leading to substantial losses for traders selling unhedged options. Conversely, index options tend to have more stable price changes, making them more efficient for strategies aiming to profit from time decay, known as positive Theta.

"Selling option premium" involves earning from time passing by. These strategies have positive Theta and negative Gamma, not relying on rising prices for profits. Opting for index options when focusing on collecting time decay can be a more effective approach for traders.

Key Takeaways

  • Trading index options can be risky, so it's crucial to grasp how it works. Understanding the process is key to managing the risks involved in this type of trading.
  • AM-settling index options are those that conclude in the morning and depend on the price at which trading begins for their settlement.
  • PM-settling index options are determined by using the final price at which all stocks in the index were traded.
  • Unexpected news can cause costly surprises as it impacts the starting price of trading.

American vs European Options Settlement Price

The settlement price is the final closing price used when options expire. Options that are out-of-the-money or at-the-money expire without any value, meaning they are worthless.

It's crucial to have a good grasp of the process when trading index options. Newcomers often face significant losses because they don't fully understand these basics. The determination of the settlement price for AM-settled options can be challenging to comprehend, which adds to the complexity.

  • At the end of business on expiration Friday, the final trade of a stock decides the settlement price. However, this isn't the case for certain European-style options like RUT, NDX, and 3rd-Friday SPX, which expire in the morning and follow a different settlement process.

To make things more complex, there are two different ways to figure out the settlement price based on the features of the option.

AM-Settled Options

Initially, SPX options only expired on the 3rd Friday of each month. But now, there are other expiration dates like Weeklys and end-of-month expiration. The settlement prices for RUT, NDX, and the original 3rd-Friday SPX options are determined using the opening stock price for each stock in the index.

These options stop trading on Thursday, a day before expiration Friday. Traders who don't close their positions by then face overnight risk. If the market opens significantly higher or lower on Friday, the settlement price can differ greatly from Thursday's closing price.

No trading happens on Friday, so if the market moves unfavorably, there's no way to take action. Failing to cover a short options position before this time can lead to settling at a very unfavorable price. I recommend that those selling options avoid holding these AM-settled options until expiration Friday.

The original index options, like the 3rd-Friday SPX, NDX, and RUT options, have always been "AM settled," and this naming practice has continued.

For "AM settled" options, the settlement price is calculated based on the index price derived from the opening price of each stock in the index. This price isn't reflective of the actual market price.

PM-Settled Options

"PM settled" options were later introduced, referring to options where the settlement price is the final price of the specific index at the end of the trading day.

SPXPM and SPXW options (weekly and end-of-month) are traded on expiration Friday. The exercise-settlement value for these options is the official closing price of the S&P 500 Index reported by Standard & Poor's on that day. SPXPM options are like the original SPX options but trade for one additional full trading day (expiring on Friday). SPXW options expire on a weekly or monthly basis, excluding the 3rd Friday. SPX EOM (end of month) options are PM-settled and expire on the last business day of the specified calendar month.

For "PM settled" options, the settlement price is the actual closing price of the index, reported by Standard & Poor's.

Subtle Difference Between PM and AM

There's a subtle difference between PM settled and AM settled options in how their settlement prices are determined. PM settled options use the index value calculated based on the most recent prices of individual stocks traded. For stocks that haven't traded recently, the last known price is used.

On the other hand, AM settled options rely solely on the opening price for the calculation. Typically, the settlement price, which is disclosed at 1:00 PM ET for SPX and after the market closes for NDX and RUT, doesn't bring any surprises. However, in cases where the market opens with a significant gap, the situation can be very different, resulting in unexpected and sometimes extreme values, catching uninformed traders off guard.

How Surprises Occur

Stay alert to situations that might lead to unexpected settlement outcomes.

Bad News in the Air

When the U.S. market is about to open at 9:30 am ET, if there's a lot of stock being sold due to bad news, like political turmoil, unexpected earnings reports from big companies, or significant drops in Asian and European markets, it often leads to lower opening prices.

SPX Opening Price Thrown Off

Five minutes after the market opens, some stocks in the index might still not have started trading because there are more sell orders than buyers. When Standard & Poor's reports the "current" SPX value at this time, it includes the previous day's closing prices for these stocks that haven't begun trading yet. This might make it seem like the SPX index only slightly dropped at the opening. However, this initial SPX price isn't the final settlement price. The actual settlement price can't be figured out until all stocks have started trading.

Stock Doesn't Trade

When there's an excess of selling (or buying), it's crucial to find buyers (or sellers) to match and agree on a fair price that reflects the current market conditions. Until this agreed-upon price is found, the imbalance stays, and the stock doesn't change hands through trading.

Sell Imbalance Remains

Think about what occurs when there's an excess of sellers for certain stocks, but the overall market, where trading has started, gets stronger. As more buyers come in, the sellers become fewer in number compared to the buyers. This leads to a gradual increase in stock prices. Consequently, the pressure to sell on stocks that haven't yet begun trading eases, allowing them to eventually start trading. However, when they do start trading, their prices are still notably lower than the closing prices of the previous day.

Market Rallies

Once almost all 500 SPX stocks have been traded, the stock market finishes its upward movement, and the final published SPX price might be, for instance, two points higher. The rest of the trading day passes without much happening, and the lowest published SPX price shows a decrease of 7 points. Traders who were short on slightly out-of-the-money puts feel better because they believe those puts didn't become valuable or move into a profitable position.

Settlement Price Ignores Rally

Understanding that the settlement price doesn't consider the market's rise is crucial. It relies on the first trades of the day for each stock. Some trades happened when the market was at its worst, and even later trades were at prices lower than the previous day's close. This means that despite the market's improvement, the newly traded stocks still add to a decrease in the SPX settlement value.

Sellers Suffer

After the settlement price (SET) is revealed, put sellers feel distressed when it's announced as 20 points lower than the previous day's close. They might cry foul play and think that option traders tricked them. However, the reality is that these traders didn't know the rules and have only themselves to hold accountable for the outcome.

How to Avoid AM Settlement Risk

Avoiding potential losses in your account is quite simple in this situation. Understand the specifics of the options you're trading and learn how to steer clear of risks. To sidestep the risk of AM settlement, close your positions on the final day the options are traded. There's no good reason to hold index options that will expire when the market opens.

Take note that OEX options are different—they're cash-settled and American style. It's better for traders who sell options without protection or use option spreads to steer clear of OEX options.

Written by Sauravsingh

Techpreneur and adept trader, Sauravsingh Tomar seamlessly blends the worlds of technology and finance. With rich experience in Forex and Stock markets, he's not only a trading maven but also a pioneer in innovative digital solutions. Beyond charts and code, Sauravsingh is a passionate mentor, guiding many towards financial and technological success. In his downtime, he's often found exploring new places or immersed in a compelling read.

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