Do Not Trade Index Options When You Don’t Know the Rules

In response to yesterday's post about a friend you was assigned early on a 4-lot, I received a VERY disturbing reply at approximately 5PM (ET) yesterday – Thursday Dec 17. 

Here is the reply in it's entirety:


A better Christmas gift was the 22k I made today when my CTM (1055-1075 / 1125-1145) SPX IC expired OTM! 


I can understand the happiness in the anonymous (unless his name really is John Doe) comment – despite the gloating attitude.

But the fact that John believes his options have expired makes me very upset.  How can this happen?  How can anyone have so much money at risk and not understand the rules of the game?

Here's my reply:

***

John Doe,

You are under a VERY serious misconception.

1) Your CTM spread is still CTM.  And will remain that way until after the market opens today.  Today is expiration Friday (technically the options expiration date is tomorrow) and today is the day that the final SPX closing price for the December expiration cycle is determined.

2) I agree that your position seems reasonable and the chances that your options will indeed expire worthless are decent.  But your options have not expired; the settlement price for SPX has yet to be determined; and it is still possible to lose the maximum amount, or $2,000 per iron condor.

3) Settlement price (symbol = SET) is calculated from TODAY'S opening price for each of the 500 stocks in the index.  When each of the 500 opening prices is known, then SET is calculated as if each stock were trading at its opening price at the same time.  In other words, SET is not a real price.  You never see an SPX quote at that price.  But it's the ONLY SPX value that is used to determine which options are in, at, or out of the money.

If you get a quiet opening, you will come out okay.  If the market gaps, you will not immediately know your fate.

4) That calculated price, SET, will not be announced until approximately
1PM ET tomorrow.  Many times, bewildered, inexperienced index option traders believe they have escaped unscathed, only to discover they have a large loss resulting from a Friday morning gap. 

SET is
OFTEN much higher or lower than the opening SPX print.


5) I hardly consider this to be a Christmas gift. To me, you are taking an incredible risk.  And what makes that so terrible is that you have no idea your options are still very much alive. 

How can you trade without knowing how European style options are settled? How is that possible?  Did you know that you were trading European options?

I don't know if I am more upset with you, your broker, or the world of options education that allows you to play the game when you don't know the rules.

At Options for Rookies, I've posted about this problem and its importance.

***

Having vented my frustration at I know not whom, John posted another comment assuring me that he knows what he is doing.  And I'm sure he does.  He was merely a bit premature with the expiration.  I see no reason to cancel my comments, so they remain as a warning to others.

***

ADDENDUM:  All's well that end's well, but I still find the play too risky for me.  Congratulations to John Doe on his winning trade.

554

6 Responses to Do Not Trade Index Options When You Don’t Know the Rules

  1. Steve 12/18/2009 at 5:46 AM #

    I did some research on this when I got involved in writing SPX options.
    I looked back at SET values over 138 months and compared them with the Thursday close of the SPX.
    The greatest positive difference was +72 points (9/18/2008)
    The greatest negative difference was -45 points (9/20/2001)
    135 of the 138 settlements were contained within 30 points of the Thursday SPX close. The other 3 problem SETs were at times of great volatility.
    My rules are:
    – If VIX on Thursday morning is less than 30, then any option more than 40 points out of the money at Thursday close can be allowed to expire.
    – If VIX is greater than 30, BTC any option within 100 points of the money by Thursday close.
    Steve

  2. Mark Wolfinger 12/18/2009 at 8:45 AM #

    Steve,
    That’s a sound rule.
    I would not feel very comfortable being 20 SPX points OTM. But, it is an individual decision.
    Thanks for sharing.

  3. Peter 12/19/2009 at 12:39 AM #

    A little off-topic, but I dislike the open expiration of the index options very much. All you can do is watch the settlement price that day, so if your shorts are anywhere near the money you have to exit early. I deal with it because it’s the way it is, but I’m curious why or what the history is behind the open expiration for European style index options? Thanks.

  4. Mark Wolfinger 12/19/2009 at 8:30 AM #

    Peter,
    I hate it also.
    My cynical, but random, guess as to why this method was chosen is that some group of people supported the idea because they figured out a way to profitably exploit the process.
    For my comfort zone, holding a position later than Thursday’s close is just too risky for the potential reward.
    As you know, we have no choice.
    I will see if I can find out why Europeans style options were chosen. I would much prefer CASH SETTLED options with a ‘normal’ Friday afternoon closing.
    But even that process can be manipulated with a flurry of ‘market on close’ orders.

  5. Peter 12/19/2009 at 3:06 PM #

    Thanks for checking it out.

  6. Mark Wolfinger 12/21/2009 at 11:20 AM #

    I tried to get a historical perspective from the Options Clearing Corporation, but they have nothing useful to offer on this topic.
    Sorry.