When stocks fall like they could in this current environment, it is extra imperative that option traders know how settlement works.
Traders and investors have been navigating through a mostly neutral and relatively low IV as of late. Despite the low IV, selling premium is an option strategy that many traders consider when attempting to extract money from the markets. Selling cash-secured puts is an option strategy investors consider when trying to purchase stock at a ‘discount” or to just generate some extra premium for their portfolio. But when stocks fall like they could in this current environment, it is extra imperative that option traders know how settlement works.
A question that is often asked in Group Coaching and one that is probably not discussed enough when learning to trade options is that of the various settlement issues. Many option traders limit their universe of option trading to two broad categories. One group consists of individual equities and the similar group of exchange traded funds (ETFs). The other group is composed of a multitude of 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 has a corresponding ETF, the 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 days there are more and more ETFs and equities that also have weekly settlements too. These contracts are of American type and as such can be exercised by the owner of the contracts for any reason whatsoever 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 in many cases. The settlement price against which these decisions are made is the price of the underlying at the close 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 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. Like ETFs and equities, these index options also have weekly settlements as well.
One critically important fact with which the trader needs to be familiar with 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 has the following two characteristics 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, and 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 a routinely monitored to avoid any surprises. When in doubt the best way to go is to ask your broker how they will handle settlement for your particular situation and tell you what alternatives you might have.