Options Settlement explained – SPX, NDX and RUT

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• Options Settlement explained SPX, NDX and RUT

• Options Settlement explained for Equities and
  Indices
• Author Hari Swaminathan

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• The process of Options settlement can be
  somewhat confusing for newcomers.  The following
  process applies to Monthly Options. There are
  Weekly Options that expire at the close of every
  Friday, and this includes equities that have
  Weekly Options, and also the Index products
  SPXlt RUT and NDX.. 
• First of all, there are two types of Options
  settlement   American style and European style.
   And there are two baskets of securities when it
  comes to settlement procedures 1) Equities and
  ETFs and 2) Major Indices like the SPX, NDX and
  the RUT. The American style applies to all
  equities and ETFs, and the European style applies
  to cash settled index Options. And there are two
  ways to settle them 1) Exchange of securities
  and 2) Exchange of cash. And there are two
  different days when these baskets are settled
  one on the third Thursday of every month but
  settles based upon the opening price on Friday
  morning and the other on the closing prices on
  the third Friday of every month. Youre forgiven
  if youre utterly confused but please read on.
  This is important stuff.

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• American style Options can be exercised at any
  time prior to the day of expiry of the Option.
  The American style applies to all equities and
  ETFs (Basket 1), including ETFs based on indices
  like the SPY or QQQ. They trade until the close
  of every third Friday of the month. The
  settlement price is the closing price on the
  third Friday. If youre an Option seller of
  equities or these ETFs, and if the Option is
  already In The Money, you have to be careful
  because you could be assigned at any time prior
  to the day of expiry. And if youre an Option
  buyer and your Option is ITM, then you will be
  automatically exercised, unless you have informed
  your broker specifically that you dont intend to
  exercise. This applies even if the Option is ITM
  by 1 cent. This type of settlement is done by
  exchange of securities. 
• The other style of settlement is knows as
  European style here, an Option can only be
  exercised on the day of expiry, and not before.
  In this case, whether youre a buyer or seller,
  you generally dont have to worry about exercise
  or assignment until the very last day of expiry.
  In the US markets, only Options on the major
  indices like the SPX, NDX and the RUT are
  European style. And these Options are also
  cash-settled meaning the settlement process
  only involves transacting in cash between the
  buyers and sellers. There are no underlying
  securities that exchange hands. In fact, these
  indices are not tradable securities. The
  settlement day for these Options are a little
  strange they trade until the Thursday before
  the third Friday. However, settlement is not
  based upon the closing prices on Thursday. They
  are based upon the opening prices on the next day
  the following Friday morning.

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• And this is where they get even more strange
  (and if you trade these securities, you have to
  watch for this). Because the price of the Index
  is calculated from the individual stocks that
  make up the Index, the opening price of the Index
  itself has to be calculated that Friday morning
  based upon the opening prices of all its
  component stocks. And this might take all morning
  to calculate. Why ? Because some stocks in the
  Index may be so thinly traded that the first
  trade does not appear until 11 am or noon. And
  the Index calculation has to wait until every
  last stock in that Index has started trading.
  There are several issues with this process 1)
  You have to wait until noon before you know where
  the Index opened. So your capital is blocked
  until that time. You might have Options that you
  believe have expired worthless, but your capital
  is blocked until the settlement process is
  completed. 2) If there are large movements
  overnight, its possible that these indices will
  open at a very different price than what they
  closed at on Thursday evening. 
• Due to this overnight exposure, its common to
  see Options on the SPX, NDX and the RUT that are
  clearly out of the money on Thursday evening by
  at least 5 still retain quite a bit of premium
  (like 1 or 1.5 on the SPX). You might be
  wondering why this premium exists when its
  clearly Out of the Money. Its precisely because
  market makers have priced those Options for the
  potential of any large overnight movement. If
  youve sold Options or spreads that are very
  close to the money on Thursday evening, it may be
  best to close them on Thursday itself and not
  risk big moves on Friday morning. And bear in
  mind, on Friday morning these Options are
  locked, so you cannot sell them or do anything
  with them. You have to wait until the Index is
  settled. This is not a situation you want to find
  yourself in. 
• If you have any questions, please post them here.

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