How index options settlement works

TK All-Star posted on 09/28/09 at 09:43 AM

Mark Wolfinger explains a common puzzler among options traders.

In my last post Euro- vs. American-style options I explained the differences between these two options styles, which are often more far-reaching than traders realize.

Today I want to explain a related issue that has stung many an options trader: how is an index option’s settlement price determined? You’d think it’d be simple – but, as many traders discover, that’s thinking wrong.

The settlement price determined on Friday is often substantially different from the closing price on Thursday afternoon. That’s why holding an open position into settlement is very risky.

Here’s how index settlement works. On the morning of the 3rd Friday, the opening price of each individual component of the index is determined. It does not matter at what time each stock opens for trading. Some open right at the opening bell, while less active issues may not trade for several minutes. If news is pending, it's possible that one or more stocks may not open until hours later, or not before the closing bell.

Once each stock has opened and an official opening price has been established for each, then a theoretical index price is calculated based on what the index would be worth if each of the stocks were trading at its opening price at the same time. This is a fictional index price; it is not a real-time, or even technically a real price.

There is a virtual certainly that all stocks will never simultaneously trade at their opening prices. By the time some stocks open for trading, it's very likely that many of the stocks that opened earlier will already be trading at a different price - higher or lower.

This is the key that so many people miss: Because the stocks are never all trading at their opening prices at any one time, the settlement price is going to be different (in some cases, very different) from any posted price for the index. Many times the settlement price is much higher (or lower) than the opening few prints for the index, and in fact, many times the settlement price is substantially higher than the daily high, or lower than the daily low, for the index.  

Those traders who were short the ITM options (or the OTM options that are now ITM) scream upon seeing the settlement price, feeling that they were cheated or that the game is rigged. Nope. The only thing that's true is that those scream the loudest were trading options when they failed to understand the rules of the game.

You, the investor, must read the materials given to you and not assume everything works the way you assume it does. And when the settlement price is much lower than anticipated, you may be upset by the results, but if you understand the process, there is no longer any reason to go nuts. The best you can do is learn from the mistake of holding a position into Friday morning, and make sure you understand the how the settlement price is calculated next time.

Of course, if you’re reading this and educating yourself in advance, hopefully you’ll never be a victim of the settlement price calculation – even once.

Settlement price (SET) for SPX is usually announced near 1PM (Eastern Time), but it can be delayed.  The settlement prices of other indexes usually are not published until after the market closes for the day.


Regards,
Mark Wolfinger
Founder, MDW Options
TradeKing All-Star Commentator

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options.

Any strategies discussed and examples using actual securities and price data are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. In reading content in the Trader Network, you may gain ideas about when, where, and how to invest your money. Although you may discover new ideas or rationale that may be compelling, you must ultimately decide whether or not to put your own money at risk. Consider the following when making an investment decision: your financial and tax situation, your risk profile, and transaction costs.

Mark Wolfinger maintains a cross-marketing relationship with TradeKing.
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Posted by TK All-Star on 09/28/09 at 09:43 AM

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