The process of Options settlement can be somewhat confusing for newcomers. The following process applies to Monthly Options. There are Weekly Options that expire at the close of every Friday.
First of all, there are two types of Options settlement – American style and European style. And there are two baskets of securities when it comes to settlement procedures – 1) Equities and ETFs and 2) Major Indices like the SPX, NDX and the RUT. And there are two ways to settle them – 1) Exchange of securities and 2) Exchange of cash. And there are two different days when these baskets are settled – one on the third Thursday of every month but settles based upon the opening price on Friday morning and the other on the closing prices on the third Friday of every month. You’re forgiven if you’re utterly confused but please read on. This is important stuff.
American style Options can be exercised at any time prior to the day of expiry of the Option. The American style applies to all equities and ETFs (Basket 1), including ETFs based on indices – like the SPY or QQQ. They trade until the close of every third Friday of the month. The settlement price is the closing price on the third Friday. If you’re an Option seller of equities or these ETFs, and if the Option is already In The Money, you have to be careful because you could be assigned at any time prior to the day of expiry. And if you’re an Option buyer and your Option is ITM, then you will be automatically exercised, unless you have informed your broker specifically that you don’t intend to exercise. This applies even if the Option is ITM by 1 cent. This type of settlement is done by “exchange of securities”.
The other style of settlement is knows as European style – here, an Option can only be exercised on the day of expiry, and not before. In this case, whether you’re a buyer or seller, you generally don’t have to worry about exercise or assignment until the very last day of expiry. In the US markets, only Options on the major indices like the SPX, NDX and the RUT are European style. And these Options are also “cash-settled” – meaning the settlement process only involves transacting in cash between the buyers and sellers. There are no underlying securities that exchange hands. In fact, these indices are not tradable securities. The settlement day for these Options are a little strange – they trade until the Thursday before the third Friday. However, settlement is not based upon the closing prices on Thursday. They are based upon the opening prices on the next day – the following Friday morning.
And this is where they get even more strange (and if you trade these securities, you have to watch for this). Because the price of the Index is calculated from the individual stocks that make up the Index, the opening price of the Index itself has to be calculated that Friday morning based upon the opening prices of all its component stocks. And this might take all morning to calculate. Why ? Because some stocks in the Index may be so thinly traded that the first trade does not appear until 11 am or noon. And the Index calculation has to wait until every last stock in that Index has started trading. There are several issues with this process – 1) You have to wait until noon before you know where the Index opened. So your capital is blocked until that time. You might have Options that you believe have expired worthless, but your capital is blocked until the settlement process is completed. 2) If there are large movements overnight, its possible that these indices will open at a very different price than what they closed at on Thursday evening.
Due to this overnight exposure, its common to see Options on the SPX, NDX and the RUT that are clearly out of the money on Thursday evening by at least $5 still retain quite a bit of premium (like $1 or $1.5 on the SPX). You might be wondering why this premium exists when its clearly Out of the Money. Its precisely because market makers have priced those Options for the potential of any large overnight movement. If you’ve sold Options or spreads that are very close to the money on Thursday evening, it may be best to close them on Thursday itself and not risk big moves on Friday morning. And bear in mind, on Friday morning these Options are “locked”, so you cannot sell them or do anything with them. You have to wait until the Index is settled. This is not a situation you want to find yourself in.
If you have any questions, please post them here.