SteadyOptions is an options trading forum where you can find solutions from top options traders. TRY IT FREE!

We’ve all been there… researching options strategies and unable to find the answers we’re looking for. SteadyOptions has your solution.

Sign in to follow this  
Followers 0

How index options settlement works


Those who have been trading options on major indexes like RUT, SPX or NDX know that those options behave differently from regular options. They usually stop trading on Thursday however the settlement value is not determined until the market opens the following day (Friday). (SPX weekly options are an exception). But that's not all.

According to CBOE:

 

Exercise will result in delivery of cash on the business day following expiration. The exercise settlement value (RLS) is calculated using the first (opening) reported sales price in the primary market of each component security on the last business day (usually a Friday) before the expiration date. The exercise-settlement amount is equal to the difference between the exercise-settlement value and the exercise price of the option, multiplied by $100.

 

The RLS is described as the RUT Flex Opening Exercise Settlement. The RLS is calculated by taking the opening price of each of the Russell 2000 stocks. Each day when the market opens all stocks don't start trading at the same time. So RLS might be very different from the opening value of RUT on Friday. In fact, it is possible that RLSs value will to be higher or lower than the RUT daily bar high/low.

 

How is it possible that the value of the highest value of the RUT is less than the RLS opening price? It is due to the fact the RLS is based on the stocks opening price whilst the RUT is based on the Index value at that time. So if all the stocks in the RLS open at their days high and then trade down then the RLS will have a value much higher than the RUT.

 

How does it impact the options traders?

 

Lets take a real life example based on one of the recent expirations.

 

On Thursday September 6th, RUT was trading in the 1026-1031 range. A trader was long a 1030 call calendar spread:

Long September 13 1030 call

Short September 6 1030 call

 

Please note that the short calls were expiring the next day and the long calls the next Friday, a week later.

 

With 5 minutes left before the closing bell, RUT was trading around 1028. The long options were worth $9.25 and the short options $2.00. A trader was facing a dilemma: should I close the trade at $7.25 or should I leave it for one more day? By closing the trade, he would leave a lot of money on the table - the value of the short options is pure time value. So his thinking was: if RUT stays around the same levels the next day, the long options will probably lose some value due to the time decay, but definitely much less than the $2 that he could keep from the short options. Right?

 

BIG MISTAKE... HUGE!!

 

Lets see what happens the next day.

 

RUT opens at 1028, basically unchanged. The long options are trading around $7.50, so still slightly higher than the value of the whole spread the day before. But wait - what about RLS? CBOE does not publish the value of RLS till the late afternoon. When this value has been published, it was very bad news for our trader: 1034.93. That means that the next day his account will be debited $493 (the difference between the RLS and the strike price multiplied by 100). The effective sell price of the calendar spread is now 7.50-4.93=2.57. That's a whopping 65% less than the spread was worth the previous day.

 

By the way, the RUT high of the day was 1034.77, lower than the value of RLS.

 

Conclusion

 

When you trade spreads like calendars based on cash settled indexes, NEVER EVER let one of the legs to expire. Always close both legs as a spread. I recommend doing it for stock calendars as well, but with stock calendars, you are at least protected because worst case you are assigned long or short stock and it is protected by the long leg. With cash settled indexes, this is not the case, and your losses can be HUGE.

Important note: The article refers to indexes that settle on Friday AM. There now many additional weekly options that settle on Friday PM, and this is a completely different story.

 

Related articles:

What Is SteadyOptions?

Full Trading Plan

Complete Portfolio Approach

Diversified Options Strategies

Exclusive Community Forum

Steady And Consistent Gains

High Quality Education

Risk Management, Portfolio Size

Performance based on real fills

Try It Free

Non-directional Options Strategies

10-15 trade Ideas Per Month

Targets 5-7% Monthly Net Return

Visit our Education Center

Recent Articles

Articles

  • Option Equivalence

    Some option positions are equivalent – that means identical profit/loss profiles – to others. Others are not. A few days ago I had an inquiry from a person trading options in a restricted account (e.g. an IRA that did not allow marginable trades or short options positions):

    By cwelsh,

    • 0 comments
    • 67 views
  • Investment Ideas for Conservative Investors

    Investors with low willingness or need to take risks often look to bank and/or life insurance company fixed-rate products to increase potential returns instead of leaving their money in conventional checking or savings accounts. Some of these product types are CD’s, structured notes, fixed annuities and fixed indexed annuities.

    By Jesse,

    • 0 comments
    • 152 views
  • iVolatility Tools: Advanced Ranker

    Here is one of the analytical tools that allows us to claim "In options we are Big Data!" For those who want to find the movers and shakers, Advanced Ranker does the job. The Advanced Ranker combines an easy to use interface with a powerful sorting logic built on IVR and IVP.

    By Levi Ioffe,

    • 0 comments
    • 132 views
  • Two Pre-earnings Momentum Trades With a Technical Trigger in Alphabet

    Both option trading backtest approaches rely on the fact that there has been a bullish momentum pattern in Alphabet stock 7 calendar days before earnings. Further, we use moving averages as a safety valve to try to avoid opening a bullish position while a stock is in a technical break down, like the fourth quarter of 2018. 

    By Ophir Gottlieb,

    • 0 comments
    • 298 views
  • Flaws in Implied Volatility

    A technical study of chart patterns, focusing on historical volatility of the underlying, reveals that depending on implied volatility is a flawed idea. Traders should remember that options are derivatives, meaning their premium value is derived from historical volatility.

    By Michael C. Thomsett,

    • 0 comments
    • 381 views
  • 7 Trading Cliches For Novice Traders

    Trading is a tough business. There is no easy money in the stock market, but there are a lot of folks who will easily take your money. What is important to know that no matter how experienced you are, mistakes will be part of the trading process. This article should help you to avoid some of those mistakes.

    By Kim,

    • 0 comments
    • 347 views
  • Iron Condor vs. Iron Butterfly

    Iron Condor and Iron Butterfly are both very popular strategies. Both of them are usually used as non-directional strategies (although butterflied can be used as a directional trade as well). Both trades are vega negative and gamma negative, but there are also few important differences between those two strategies.

    By Kim,

    • 0 comments
    • 350 views
  • Leveraged Anchor: A Three Month Review

    Steady Options has now been tracking the Leveraged Anchor from the unlevered version for three months.  The results so far have substantially beat expectations, though there is a possibility for improvements discussed at the end of this piece. 

    By cwelsh,

    • 10 comments
    • 1,058 views
  • How a Fund is Developed

    Many individuals are curious as to the testing process for a new fund.  With the plethora of funds continually being developed, having some insight into this process can be helpful for investors.  At the very least, it can provide a series of questions which should be asked in conducting due diligence on fund managers.

    By cwelsh,

    • 0 comments
    • 284 views
  • Why Dow Points Are Meaningless

    A quick online search for “Dow rallies 500 points” yields a cascade of news stories with similar titles, as does a similar search for “Dow drops 500 points.” These types of headlines may make little sense to some investors, given that a “point” for the Dow and what it means to an individual’s portfolio may be unclear.

    By Kim,

    • 0 comments
    • 315 views

  Report Article
Sign in to follow this  
Followers 0


We want to hear from you!


Thanks Kim, i have been watching this and thinking a bit about it. Basically these options have an untradeable Twilight Zone where bad things or good things can happen. However, I am interested in the "$2.0" of residual value, tempting to go for but in this case not enough. Obviously it is a guess as to where the prices open the next day and when the trading closes the day before close to the strike you do not know if you are in fact ATM, OTM or ITM but how does a market maker decide where to close it? How do they (or in fact the market) fix on a $2.0 residual value, is this something we can calculate from the futures prices as presumably they are hedging their delta this way??

Share this comment


Link to comment
Share on other sites

I guess it depends then on the cost and benefit of trading RUT vs. IWM. 

 

You are saving about $7/size by trading 1 contract of RUT vs. 10 contract of IWM. But I guess you get the more predictable settlement. I think I'm going to go with IWM next time we trade RUT to see whether the theta decay on last day if the underlying is sitting comfortably in tent is worth more than the commission cost. 

Share this comment


Link to comment
Share on other sites

Oops after entering a SPY DC, I realized that my math is completely wrong. It is $7/contract difference; so since if we are trading double calendars, it is 4 leg position, the difference would $28 per contract, quite sizable commission difference esp. if you take into account more adjustments etc. 

Share this comment


Link to comment
Share on other sites

The question is: do you really want to hold that long? As you get closer to expiration, your negative gamma becomes huge. I prefer to close at least one day before expiration anyway.

 

Besides commissions, there is also a slippage issue. With RUT calendar, I'm usually able to get in/out at around 5-7 cents above/below the mid. That's less than 1 cent for IWM. Even 10 cents in RUT translates to 1 cent in IWM. I believe that minimal slippage for IWM spread would be 2 cents.

Share this comment


Link to comment
Share on other sites


Create an account or sign in to comment

You need to be a member in order to leave a comment

Create an account

Sign up for a new account. It's easy and free!


Register a new account

Sign in

Already have an account? Sign in here.


Sign In Now

Options Trading Blogs