Expiration Horror Stories: A.M. vs P.M. Index Settlement

When I started trading options way back when, the S&P 500 futures were worth $500 a point, I could eat five of my mother's cannolis without gaining weight, and everything expired on a Friday afternoon—stock and index options, futures and futures options, everything. Simple.

When interest rates were higher, there was a lot more index arbitrage going on. Big trading firms would try to make money on cost-of-carry trades by taking positions in the underlying stocks in an index and offsetting them with index options and futures. Only trouble was, at expiration, they'd have to unwind their positions. Because they'd hold on to them until the bitter end, they'd do all of this trading on the afternoon of expiration Friday. And man, you can imagine what it was like. Order imbalances to buy or sell, wild swings in the indexes, market makers taking the other side of all the action. It was great. But what was happening was that even though the arbs weren't really trying to guess which way the market was going—their positions were largely delta neutral—it could create huge changes in the prices of the underlying stocks. This was especially true at what was known as “Triple Witching,” which happened in March, June, September, and December when the index futures expired.

The exchanges eventually decided to make most cash-settled index options, like the SPX, NDX, RUT, and DJX, expire on Friday morning. In the old days, the index settlement price was based on the prices of the individual component stocks at the close of trading in the afternoon—p.m. Now, the settlement price is based on the opening prices of the component stocks on Friday morning—a.m. The idea was that some of the heavy trading activity would be transferred to Friday morning, and reduce the volatility in the market.

And that's all well and good, but it means you have to adjust a bit. Like, the S&P 500 futures are now worth $250 a point, and I can still eat five cannolis, but then I'm not eating lunch for the next two days. The trick is that because most cash-settled index options stop trading on Thursday afternoon, and settlement isn't determined until Friday morning, there's a whole Thursday night's worth of risk if you hold those expiring options. Let's say you're short a call vertical (spread) in one of those cash-settled indexes, and it's out of the money at the close of trading on Thursday afternoon. You may think you're in good shape to keep the profit on that trade, but you might end up having that trade turn into a max loss if there's a rally overnight into Friday morning.

What happens is that the settlement price is based on the price that each stock opens with, and all stocks don't necessarily have trades at the open of trading at 8:30 a.m. Central time. Some of them take a few minutes, and in the case of the Russell 2000, some stocks don't have a trade until well past the first hour. That can delay the calculation of the settlement price, which means it can even be outside of the high or low index price on Friday morning. Holding on to that position for the one extra night can be nerve-wracking and very costly.

So, just like my mother told me to wipe my face after eating cannolis, consider cleaning up your positions in those cash-settled options as they approach expiration. They represent nothing but risk, and even though you'll pay commissions, you won't be subject to any unpleasant mark-ups or mark-downs in the a.m. settlements.