Using index options instead of individual stock options has some advantages. Traders who rely on income-generating strategies (such as selling options) depend on price stability to make a profit. These strategies may provide reduced returns for the trader compared to the stock market as a whole. This is expected because no strategy can outperform the averages every time.
Key Takeaways
Trading index options is risky, so understanding the process is essential. Index options that meet settlement criteria in the morning close based on the opening trading price. Index options that meet settlement criteria in the afternoon use a different price that had been traded for all stocks in the index. News events can lead to costly surprises as they affect the opening price.
The Nuances Between Morning Settlement and Afternoon Settlement
“Morning settlement” options were initially introduced, and these terms refer to options that expire in the morning (RUT, NDX, and SPX on the third Friday). To complicate matters further, there are two distinct methods for calculating the settlement price, depending on the characteristics of the option.
Morning Settlement Options
Initially, SPX options only expired on the third Friday of each month. Today, there are other expiration dates (weekly and end-of-month). Settlement prices for RUT, NDX, and “original SPX options on the third Friday” are calculated using the opening stock price for each stock in the index.
These options stop trading when the market closes on Thursday, the day before the expiration on Friday. Therefore, any trader who does not close all positions before trading halts on Thursday faces overnight risk. If the market rises or falls on Friday, the settlement price will be very different from Thursday’s closing price.
Options do not trade on Friday, and you cannot do anything to mitigate an unfavorable market opening. If you fail to cover a short options position (whether naked or part of a spread), your position might settle at a highly unfavorable price. I recommend that short option sellers do not hold these morning settlement options until the expiration Friday.
The original index options, SPX on the third Friday, along with NDX and RUT options, have always been “morning settled,” and these names persisted.
Afternoon Settlement Options
Later, “afternoon settlement” options were introduced, referring to options whose settlement price is the final price of the day for the specified index.
SPXPM and SPXW (weekly and end-of-month) options trade on the expiration Friday. The exercise and settlement value is the official closing price of the S&P 500 index as reported by Standard & Poor’s on the expiration Friday. Note: SPXPM options resemble the “original SPX options,” but SPXPM options trade for one additional full trading day (expiration Friday). SPXW options are issued to expire on a weekly or monthly basis – but not on the third Friday. SPX EOM (end-of-month) options expire on the last business day of the specified month.
The settlement price for “afternoon settlement” options is the actual closing price of the index, as reported by Standard & Poor’s.
How to Avoid Morning Settlement Risk
It is very easy to avoid this unhappy scenario affecting the value of your account. Be aware of the details of the options you are trading and know how to avoid exposure to risk. To avoid morning settlement risk, close positions on the last day the options are traded. There is no good reason to hold index options that will expire at the market opening.
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OEX options are unique. They are settled in cash and have an American style. They should be avoided by traders who sell naked options or engage in options spreads.
Source: https://www.thebalance.com/settlement-prices-can-be-unsettling-1214931
Source: https://www.thebalancemoney.com/european-options-settlement-price-2536812
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