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Index Options And Expiration Risks

With November expiration little more than a week away, we thought we'd share a cautionary tale from the options trading trenches.

Imagine yourself as the proud holder of a short 1100/1110 October RUT call spread. Perhaps you opened it a few weeks prior for $4 - risking $6 to make $4 (a 66% return on risk). But you neglect to buy back the call spread during expiration week and the RUT moves up significantly on Wednesday and Thursday.

As we all know, index options expire on the Thursday of expiration week, the day before equity options expire. In the case of the Russell 2000, the RUT options expire a day before the IWM options. This would lead most new traders to assume that the settlement price for the RUT is the closing value on Thursday.

Not so fast…

On Thursday the RUT closes at 1102, putting your spread $2 in the money but still giving you a profit of $2 (a return on risk of 33%). Not bad given that you tempted fate by holding through expiration.

Thursday at the close is the last time you can trade your spread but the RUT isn't finished with you yet.

On Friday morning, the RUT gaps up and opens at 1109. Your call spread is now $9 in the money and has put you $5 in the red. Although you've hedged your sale of the 1100 call with the purchase of the 1110 call, the 1110 is still out of the money and does nothing to defray your loss from the short 1100 call.

(click to enlarge)Click to enlarge

But wait, it gets worse.

The settlement price for the RUT is not based on the opening value of the RUT on Friday but rather the RLS index, which is published by the CBOE. As they explain it:

"The exercise settlement value (RLS) is calculated using the first (opening) reported sales price in the primary market of each component security on the last business day (usually a Friday) before the expiration date."

In plainer language, you have to wait until all 2000 components in the Russell have traded at least one share before the RLS is calculated. For thinly traded stocks, they may not trade until 30 or 45 minutes after the open. If there is a strong gap up, they will benefit from the broader trend up and trade at a higher than normal price. Once that initial price is recorded, it is added to the RLS calculation.

Given how the RLS is calculated, it's entirely possible that the RLS value could be higher than the RUT high for the day.

So let's go back to our story.

You're furious with yourself for holding until expiration and have now watched your trade erode in value, from a profit to a smaller profit to a loss to a larger loss. All the while you were unable to trade out of the position. If you've ever read the sweaty palms-inducing tales of limit down days in the Market Wizards books, you now know what that feels like.

By the time the RLS is calculated and published on the CBOE website, you discover that the settlement value is up to 1112.63. You've lost the full amount of your 10 pt. RUT call spread - $6 (width of the spread minus the credit received). The only saving grace is that your 1110 call finally kicked in and closed $2.63 in the money.

For any readers who have experienced this expiration horror story first hand, we don't need to remind you how much this hurts. For those of you who are still grasping the painful nuances of index options' settlement, here's a helpful equation:

Gap risk +
Settlement calculation method +
Inability to trade after Thursday's close =
High variability outside of your control