A lot can happen between the bells and beyond. Think you're in the clear on those short index options? You better think again.
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.
for thinkMoney ®
Financial Communications Society 2016
for Ticker Tape
Content Marketing Awards 2016
Content intended for educational/informational purposes only. Not investment advice, or a recommendation of any security, strategy, or account type.
Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.
TD Ameritrade, Inc., and its registered employee, Tony Battista, do not solicit or recommend any form of trading in the individual securities mentioned above. Please do careful, independent research before investing any money as well as weigh the possible consequences on your particular financial situation before doing so. Spreads and other multiple-leg option strategies can entail substantial transaction costs, including multiple commissions, which may impact any potential return.
Market volatility, volume, and system availability may delay account access and trade executions.
Past performance of a security or strategy does not guarantee future results or success.
Options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. Options trading subject to TD Ameritrade review and approval. Please read Characteristics and Risks of Standardized Options before investing in options.
Supporting documentation for any claims, comparisons, statistics, or other technical data will be supplied upon request.
This is not an offer or solicitation in any jurisdiction where we are not authorized to do business or where such offer or solicitation would be contrary to the local laws and regulations of that jurisdiction, including, but not limited to persons residing in Australia, Canada, Hong Kong, Japan, Saudi Arabia, Singapore, UK, and the countries of the European Union.
TD Ameritrade, Inc., member FINRA/SIPC, a subsidiary of The Charles Schwab Corporation. TD Ameritrade is a trademark jointly owned by TD Ameritrade IP Company, Inc. and The Toronto-Dominion Bank. © 2021 Charles Schwab & Co. Inc. All rights reserved.