Tales of a Technician: Beware the Slippery Settlement of Index Options
January 21, 2020
Last Update: August 2021
Usually understanding how Index options are settled doesn’t matter. But when it does – boy oh boy – you better know what’s going on. I can’t remember the last time I talked about this, and it’s a minor detail that could have mattered a ton to traders of the Cash Flow Condors system.
Today I’m going to tell you exactly what happens to RUT Index options when they die.
Stock Options
If you ever attended a basic options class, you should have learned that options either expire in-the-money (ITM) or out-of-the-money (OTM). All OTM options expire worthless, and all ITM options are automatically exercised and assigned.
Do you know what determines if the option sits ITM or OTM at expiration? It’s the settlement value. For standard stock options, this is the closing price of the underlying stock on the day of expiration. For example, January’s monthly options expired last Friday (17th).
Consider AAPL, for instance.
Friday’s close was $318.73, making it the settlement price. That means the $318 strike call expired 73 cents ITM. The $319 call expired OTM, and thus worthless. On the flip side, the $319 put expired ITM alongside any other put with a strike above it. Meanwhile, any put with a strike less than $318.73 expired worthless.
Understanding settlement for stocks is simple because it’s the closing value that all can see.
But Index options are a curious case.
The Curious Case of RUT Options
One of the first differences between stock options and RUT derivatives is the last trading day. RUT options cease trading on the third Thursday of the month, not the third Friday. If you didn’t exit your RUT condor last Thursday, then you are holding into expiration by default.
But, unlike stock options, RUT Index options settle based off of Friday’s opening prices. But it’s not the RUT’s opening print. It’s a theoretical price of the Index calculated as if all of its holdings opened at the same time. Sometimes they don’t all open at 9:30 AM on the dot. As a result, the settlement value can be different than the open. Sometimes higher, and sometimes lower.
You have zero control over this. And can get mega screwed if you roll the dice. This is why I highly (highly!) recommend exiting any short options or spreads that sit anywhere near the RUT price on the Thursday of expiration week.
I held Jan $1715/$1725 bear calls (as part of my Jan Condor) and closed them on Thursday due to the RUT pushing toward $1706. That’s way to close for comfort.
The rally continued overnight, and RUT opened Friday morning at $1712.93. Does that mean my $1715/$1725 bear call would have expired OTM?
NOPE!
Remember, the opening price is not the settlement price. For that, you have to wait a few hours after the open and check CBOE’s website. You can also chart it under the symbol “RLS” in most charting platforms. Here’s a snapshot of the settlement page on CBOE:
Note the RUT value is $1715.54. The Index didn’t even trade up to that price throughout the entire trading session. But it doesn’t matter. It settled there regardless. So, the $1715 short calls expired 54 cents ITM.
Because RUT Index options are cash-settled, that means $54 would have departed my account at expiration. If I sold the entire condor for $100, then my overall profit for the month was $46.
In hindsight, we would have been okay this go around. But can you imagine what would have happened if we were short the 1705/1715 bear call? Disaster!
On Thursday, the RUT close was $1705.22. If you mistook that for the settlement value you would have thought you were fine. Then on Friday, you wake up and discover instead of your bear call expiring 22 cents ITM; it ended $10 ITM! You went from essentially capturing your max profit of $100 to incurring a max loss of $900.
Say bye-bye to one or two year’s worth of gains!
Do me a favor. If you don’t already have a rule that states you will exit all short options trades on RUT (condor or otherwise) on the day before expiration if they are anywhere close to ATM. Then make one.
Now.
Your wallet will thank you.
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Good point! now is this only for the RUT or do other Index ETFs also have the same quirkiness at expiration as the RUT does?