A sound knowledge and understanding of how various option products are settled is critical for traders, as there are some differences and subtle nuances that must be considered.
One rarely-discussed topic that is important to understand in becoming familiar with the mechanics of option trading is that of the various settlement mechanisms.
Most traders confine the universe of their option trading to two broad categories of underlyings: one group consists of individual equity issues and the similar group of exchange traded funds (ETFs), while the other group is composed of the various broad-based index products.
These two groups are not entirely mutually exclusive since a number of very similar products exist in both categories; for example, the broad-based SPX index and its corresponding ETF, SPY.
The first category, the individual equities and ETFs, trade until the close of market on the third Friday of each month for the monthly series contracts. These contracts are of American type, and as such, can be exercised by the owner of the contracts for any reason whatsoever and at any time until their expiration.
If the contract is in-the-money at expiration by just one cent, clearing firms will also exercise these automatically for the owners unless specifically instructed not to do so. The settlement price against which these decisions are made is the price of the underlying at the final bell of the life of the option contract.
When this first group we are discussing settles, it is by the act of buying or selling shares of the underlying equity/ETF at the particular strike price. As such, the trader owning a long call will acquire a long position in the underlying, and the owner of a put will acquire a short position.
Conversely, the trader short these options will incur the offsetting action in his account. Obviously, existing additional positions in the equity/ETF itself may result in different final net positions.
The second category, the broad-based index underlyings, are also termed “cash-settled index options.” This category would include a number of indices, for example, RUT and SPX.
As the name implies, these series settle by movement of cash into and out of the trader’s account. The last day to trade these options is the Thursday before the third Friday; they settle at prices determined during that Friday morning.
One critically important nuance with which the trader needs to be intimately conversant is the unusual method of determining the settlement price of many of the underlyings. It is not the same as settlement described above.
Settlement for this category of underlyings have the following two characteristics that are important for the trader to understand:
1) The settlement value is a calculated value published by the exchange and is determined from a calculation of the Friday opening prices of the various individual equities
2) This value has no obligate relationship to the Thursday closing value for the underlying
Many option traders choose never to allow settlement for the options they hold, either long or short. For those who do allow positions to settle, careful evaluation of the potential impact on capital requirements of the account must be routinely monitored to avoid unpleasant surprises.
By Dan Passarelli of MarketTaker.com
