As a long-time Chicago Board Options Exchange (NASDAQ: CBOE) market maker, I’ve been very disappointed in how my ‘home’ exchange has handled S&P 500 Index Options (CBOE: SPX). The exchange applied some trading rules to the SPX that didn’t work for me and many other customers, but that was their right. Apparently their decision did not hurt business because SPX is a trading vehicle with world-wide support and fantastic trading volume. This topic – settlement of the SPX options at expiration – is something that touches many options trading investors.
Nevertheless, change is in the air and I love it. In fact, I plan to switch from trading the more volatile Russell 2000 (CBOE: RUT) options to trading SPX options, once the changes described below apply to all SPX options.
Goodbye (almost) to morning Settled SPX Options
In early December, the CBOE quietly transformed its Weeklys SPX options from morning settlement to afternoon settlement. That’s good news to me. I had always felt that morning settlement was simply too confusing for the individual investor who somehow could never quite grasp how the final settlement price was determined. It was not complicated, but it was never logical.
Here’s how it has worked –
When SET, the settlement price (the SPX value that determines the value of all in-the-money options) is the true closing price for the day, there is no confusion. Everyone sees the current SPX value as it changes throughout the day. There are no surprises at day’s end.
However, morning settlement is very different. To calculate SET, the index was calculated as if each of the 500 stocks in the index were trading at its individual opening price for the day — simultaneously. This is an imaginary number. All stocks do not open at the same time.
For instance, if there is buying pressure at the opening, buyers exceed sellers and the opening price of each stock is relatively high, though it usually reverses direction when the buying pressure disappears. However, it is only that initial ‘high’ opening price that is used to determine SET. Thus, SET is skewed because most stocks open with that buying pressure.
Please click through to Page 2 for conclusion of article.
(To read more option analysis and trading ideas visit Trading Strategies.)
Think about this: When buyers back off after the opening, the market tends to back off a little. Some stocks have not yet opened and there is probably still an order imbalance for them. As a result they open at those higher prices.
When all those highs are thought to have been occurring at the same time, SET is high — often significantly higher than SPX prices that everyone can see. It’s not rare to see SET exceed the day’s high by many points — or many hundreds of dollars per option.
Of course, all of the above also holds true for lower prices when there is selling pressure.
I never liked this methodology, but the true problem is for the many less sophisticated investors who had no idea how SET is determined. They may howl with disbelief upon discovering SET published at mid-day. True, it’s their own fault for not knowing what they are trading, but this is not a problem they should have been forced to face.
So, good riddance to this flawed methodology as it appears that the CBOE has come to its senses. At long last on Feb. 28, the exchange reported:
“CBOE Holdings announced plans today to list on C2, the company’s new alternative exchange, an electronically-traded version of its flagship S&P 500 Index option (SPX), which it is calling “SPXpm.” The Company submitted a rule filing to the Securities and Exchange Commission (SEC) today and plans to list SPXpm upon SEC approval.
“Under the proposed rule change … SPXpm will be identical in structure to CBOE’s traditional SPX index option product, except it will have “p.m.” settlement.”
Eliminating morning settlement makes this product viable. It was bad enough to trade a product with zero competition on other exchanges, but I avoided SPX options because of the lack of electronic markets and the unfairness (that’s a kind word for ‘stupidity’) of the method chosen as the settlement price for expiring options. [Obviously all Friday pain can be eliminated by exiting no later than Thursday.]
The quarterly SPX options that expire on the last trading day of the month are already p.m. settled. The last remaining morning-settled SPX options are the ‘regular’ options which expire on Saturday, following the third Friday of the month. It cannot be too long before the switch is turned on these puppies. I’m looking forward to that event.
Follow Mark on his ‘Options for Rookies’ blog: http://blog.mdwoptions.com
