If you are new to options trading you may have heard of both equity and index options, but maybe you aren't sure what the difference is between an American and a European style option? Or perhaps you weren't aware that some options expire near the market open while others expire at the close of trading. The purpose of this article is to highlight the characteristics of both equity and index options and make sure that you understand the differences, especially when it comes to expiration and the settlement process.
What is an equity option?
An option is a contract between two parties that gives the owner the right to buy (in the case of calls) or sell (in the case of puts) the underlying asset at a specific price up until the expiration date. The "asset" in regards to an equity option is an actual stock or ETF that is exchanged between the two parties after the option is exercised. When a (standard) call is exercised the owner receives 100 shares of the underlying security at the contract's strike price. Equity options are the most common type of option and are listed on most of the actively traded stocks or ETFs in the market today.
What is an index option?
Similar to equity options, index options have strike prices, expiration dates and can be calls or puts. However, since the underlying is an index rather than a stock or ETF, the "asset" that gets delivered at expiration is cash. An index is just a number designed to measure the value of a portion of the stock market and therefore cannot be delivered. At expiration, the difference between the value of the index and the strike price (assuming it is in the money at expiration) determines how much cash is delivered. Options are listed on many of the popular indices such as the S&P 500 (SPX), NASDAQ 100 (NDX) and Russell 2000 (RUT).
American style vs. European style
An American-style option allows the owner to exercise the option at any time prior to (and including) the expiration date. Conversely, European-style options can only be exercised at the time of expiration. All equity options are American-style options and the majority of index options are European-style options (exceptions include OEX, XAU, and SOX). While an American-style option offers more flexibility to the option holder, keep in mind that outside of some dividend scenarios, it typically does not make economic sense to exercise an option prior to the expiration date because of the potential time value remaining in the value of the contract. It's also important to note that both equity and index options can typically be closed out (sold or bought-to-close) prior to the expiration date, assuming an assignment hasn't taken place.
Expiration and settlement
Excluding weekly and quarterly options, all standard equity options expire on the third Friday of the month at the market close (known as P.M. settlement). The third Friday of the month is generally the last trading day for standard equity options. The official closing price of the stock or ETF on that Friday determines whether the option is in or out-of-the-money. An option that closes $0.01 or more in-the-money falls within the OCC's price threshold and will be automatically exercised.
Conversely, most standard European-style index options expire near the market open (known as A.M. settlement) on the third Friday of the month and stop trading at the market close on the Thursday preceding that Friday. On that Friday morning an index "settlement value" is calculated once all of the individual securities that make up the index have opened for trading. The settlement value is then used to determine which options are in-and-out of the money and how much cash is to be delivered as a result. There are different ticker symbols for the settlement values of the respective A.M.-settled indices which are updated after the market open on the morning of expiration day. Below are some of the more popular A.M.-settled indices:
|Index Name||Ticker Symbol||Settlement Ticker Symbol|
|Dow Jones Industrial Average||$DJX||$DJS|
|CBOE Volatility Index (VIX)||$VIX||$VRO|
Note: Some SPX weekly options (SPXW) have P.M settlement.
Expiration example (P.M. settlement)
In this hypothetical scenario, let's assume that it is Friday, November 20th, 2015 and you own 1 AAPL 11/20/2015 110.00 call. Since AAPL is a P.M.-settled contract, today represents both the last trading day and the expiration day for this contract. As a long call owner of an equity option, you understand that you have the following choices on expiration:
- Sell the call prior to expiration if you don't want to take a position in the underlying and you want to capture any remaining value (consisting of either intrinsic value, time value or both).
- Do nothing and let the closing price determine whether you take a position in AAPL or not
- If AAPL closes in the money by $0.01 or more you will be assigned and assume a 100 share position in the stock.
If AAPL closes out-of-the-money then the call expires worthless, or
- Notify Schwab that you don't want the call to be exercised (known as "do-not-exercise" instructions) with the intention of closing out the position prior to the market close.
Assuming you are comfortable with taking a position in AAPL, you decide to do nothing and let the closing price determine the outcome. By the market close (4:00 PM ET) the closing price of AAPL is $110.18 which means that you will be assigned 100 shares of AAPL at a price of $110.00 before Monday morning.
Expiration example (A.M. settlement)
In this scenario, let's assume that it is Thursday, November 19th, and you own 1 SPX 11/20/2015 2000.00 call. Since SPX is an A.M.-settled contract, today represents the last trading day for this contract and the expiration of this contract is tomorrow morning. As the owner of the index call option, you understand you have the following choices on the last trading day:
- Sell the call to realize the current market value of the contract. This might be done in an effort to capture any potential remaining time value and/or if you believe SPX will open lower the next morning.
- Do nothing and let the call reach expiration Friday morning. The amount of cash deposited in your account depends on the (in-the-money) difference between the strike price of the call (2000) and the settlement value ($SET).
Assuming you feel confident that SPX will open higher Friday morning, you may decide to do nothing and let the call reach expiration. On Friday morning, the SPX initially opens up 6.20 to 2112.25 but the settlement value ($SET) is determined to be 2110.47 roughly 20 minutes after the open. Since the difference between the $SET (2110.47) and the call strike price (2000) is 10.47, you find that $1047.00 (excluding commissions) has been deposited in your account before Monday morning.
Where can I confirm the option type?
You can verify whether an option is American or European style, A.M. or P.M., settled and much more by going to the contract details section. Once you are logged in to schwab.com you can go to "Research" and then "Options" and enter the option symbol to get the contract details. On StreetSmart Edge®, the details are found by going to the option chain and clicking on the yellow arrow starting at the beginning of the row that contains the option contract (see below).
Finally, below is a snapshot of an example equity and index option to help summarize the differences discussed in this article:
Equity vs. index option comparison
|Contract Size||100 AAPL||100 SPX|
|Last Trading Day||Third Friday of the Month||Thursday before the Third Friday of the Month|
|Delivery||100 AAPL @ strike price||$100 x difference between in-the-money strike and SET|
|Settlement Price||Closing AAPL Price||$SET Value @ Expiration|
Note: Some SPX weekly options (SPXW) have P.M settlement.
I hope this article helped you gain a better understanding of both equity and index options and what differentiates them. If you have any feedback regarding this article, or any other topics you would like to read, please click on the thumbs up/down icons and leave a comment at the bottom of the page.
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