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How index options settlement works
Kim posted a article in Trading BlogAccording 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: Iron Condor Adjustments: How and When Why You Should Not Ignore Negative Gamma Can you double your account every six months? Can you really make 10% per month with Iron Condors? Options Expiration: Six Things To Know