This article is aimed at alleviating some of the confusion about cash-settled indices. For the sake of simplicity, only three indices are going to be addressed: S & P 500 (SPX), Russell 2000 (RUT), and S & P 100 (OEX/XEO). None of these is the perfect product because they all have disadvantages. Figure 1 labels the imperfections of each.
|SPX||Settlement time flip-flops|
Figure 1: Disadvantages
A reader could briefly glance at these disadvantages and quickly talk him or herself out of trading the indices because of that focus on the negatives. Quantum Physics studies show us that we, the ultimate observers, create our own reality. Hence, let us look at the three cash-settle indices one by one.
It is true that RUT, beta-wise, is more volatile that either of the S&Ps. It moves in wider ranges because of the impulsiveness of the Small Caps which are prone to reacting to the news. Yet at the same time, volatility is a matter of personal preference. Some traders, mostly conservative ones, do not like big swings whereas others, moderately aggressive ones, love it. On a positive note, RUT settlement is always on Friday’s open with the last trading day being Thursday, regardless if they are weekly or regular monthly options.
Unlike the stable RUT settlement time, SPX options settlement time flip-flops between the weekly and the monthly options. The regular monthly options on SPX settle on Friday’s opening print. But the SPX weekly options settle on Friday’s close. To recap, SPX weekly settle at 4:00 PM EST and SPX monthly at 9:30 AM EST. Could that extra six and half trading hours make a difference? Affirmative! Recall Friday 06-01-2012, the SPX moved down over 30 points on that day. One extra trading day can often make such a big difference, turning a winner into a loser or vice versa.
Moving on to the third cash-settled index, the S&P 100: there are two tickers used, the OEX and the XEO. The XEO has European-Style options, just as SPX and RUT. The OEX, using the inverse spelling of XEO, are American-Style; however, pricewise XEO and OEX are the same. By the way, American-Style options have the flexibility of early assignment. For a seller of American style options this means constant risk of assignment. European-Style options also have certainty of assignment BUT only on the expiration.
To make a clear distinction between the American and European style options we should first look at both exercising the right and having the assignment. For example, if a trader chooses to exercise a long call on the American-Style options, then the trader is taking advantage of the right to buy something. When the purchase is done using margin, an interest charge is incurred. However, there is also the possibility of using exercise-and-close which can be done without involving any margin interest. The simultaneous transaction of exercise-and-close can be done even if there is not enough money in the account. No margin interest is charged because there is no risk. The exercise-and-close would incur a transaction cost. Whereas closing the obligation on our own while the market is still open by buying back what was sold would incur only a normal commission fee. Often the commission is less than an assignment or exercise fee. It also depends on the contract size.
During assignment on the American-Style options, the trader that was short is notified by the OCC (Option Clearing Corporation) about the immanent event. The trader is obliged to deliver. By contrast using European-Style options, no assignment or exercise can take place unless the positions are held beyond the expiry. In such case all in-the-money options, by any amount are settled. No margin is used because the cash-settle indices settle in cash.
Next let us look at the S&P 100 and address its disadvantage. The OEX/XEO illiquidity is a result of having only one option exchange facilitating the order flow. Should we stop trading it just because of that reason? Though there is just one market maker, the CBOE, it is one of the most reputable and best known. What if we are selling vertical credit spreads on these? When we are selling something we really need just one buyer and if the price is fair then it is acceptable.
On a positive note, fewer eyes are watching the performance of the OEX/XEO than its big brother. In addition to being less watched, the S&P 100 contains the best of the best from the basket of S&P 500 products. Quite often, the OEX moves to the upside, percentage wise, more than actual S&P 500.
Figure 2 shows Google Finance Page snap shot of OEX compared to SPX.
In conclusion, this newsletter was aimed at alleviating some of the confusion about cash-settled indices. The cash-settled indices do not have the possibility of early assignment. This is not intended to promote buying or selling of any of the discussed products. The article was strictly intended for educational purposes only. Trading options on cash-settled indices involves risk that might not be suitable for everyone. Know your trading instruments prior to trading them, always. Focus on the positives and good things will happen; have green trading.