Stock Options

Broad-based indexes have many different industries represented by their component companies. As you would expect, however, other broad-based indexes are indeed made up of many different stocks. When stock options are exercised, the underlying stock is required to change hands. But index options are settle in cash instead.

That would be ridiculous. The index value is just a gauge to determine how much the option is worth at any given time. As of this writing, all stock options have American-style exercise, meaning they can be exercised at any point before expiration. Most index options, on the other hand, have European-style exercise. As with any other option, you can buy or sell to close your position at any time throughout the life of the contract.

The last day to trade stock options is the third Friday of the month, and settlement is determined on Saturday. The last day to trade index options is usually the Thursday before the third Friday of the month, followed by determination of the settlement value on Friday. The settlement value is then compared to the strike price of the option to see how much, if any, cash will change hands between the option buyer and seller. Stock options and narrow-based index options stop trading at ET, whereas broad-based indexes stop trading at ET. If a piece of news came out immediately after the stock market close, it might have a significant impact on the value of stock options and narrow-based index options.

However, since there are so many different sectors in broad-based indexes, this is not so much of a concern. All of these are very general characteristics of indexes. In practice, there are lots of small exceptions to these general rules. Although the OEX is an index, options traded on it have American-style exercise.

This table highlights a few of the general differences between index options and stock options.

But make sure you do your homework before trading any index option so you know the type of settlement and the settlement date. As you read through the plays, you probably noticed that I mentioned indexes are popular for neutral-based trades like condors. Ally Financial Inc. Ally Bank, the company's direct banking subsidiary, offers an array of deposit and mortgage products and services. See Exercise Settlement for further explanation. An index call option is in-the-money when its strike price is less than the reported level of the underlying index.

It is at-the-money when its strike price is the same as the level of that index and out-of-the-money when its strike price is greater than that level. An index put option is in-the-money when its strike price is greater than the reported level of the underlying index. It is at-the-money when its strike price is the same as the level of that index and out-of-the-money when its strike price is less than that level.

Premiums for index options are quoted like those for equity options, in dollars and decimal amounts. The writer, on the other hand, will receive and keep this amount. The amount by which an index option is in-the-money is called its intrinsic value. Any amount of premium in excess of intrinsic value is called an option's time value. As with equity options, time value is affected by changes in volatility, time until expiration, interest rates and dividend amounts paid by the component securities of the underlying index.

The exercise settlement value is an index value used to calculate how much money will change hands, the exercise settlement amount, when a given index option is exercised, either before or at expiration. The value of every index underlying an option, including the exercise settlement value, is the value of the index as determined by the reporting authority designated by the market where the option is traded. Unless OCC directs otherwise, the value determined by the reporting authority is conclusively presumed to be accurate and deemed to be final for the purpose of calculating the exercise settlement amount.

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In order to ensure that an index option is exercised on a particular day before expiration, the holder must notify his brokerage firm before the firm's exercise cut-off time for accepting exercise instructions on that day. On expiration days, the cut-off time for exercise may be different from that for an early exercise before expiration. Note: Different firms may have different cut-off times for accepting exercise instructions from customers, and those cut-off times may be different for different classes of options.

In addition, the cut-off times for index options may be different from those for equity options. Upon receipt of an exercise notice, OCC will assign it to one or more Clearing Members with short positions in the same series in accordance with its established procedures.

Index Trading With Options | Index Options | Lakshmishree Group

The Clearing Member will, in turn, assign one or more of its customers, either randomly or on a first-in first-out basis, who hold short positions in that series. Upon assignment of the exercise notice, the writer of the index option has the obligation to pay this amount of cash. Settlement and the resulting transfer of cash generally occur on the next business day after exercise.

Note: Most firms require their customers to notify the firm of the customer's intention to exercise at expiration, even if an option is in-the-money. You should ask your firm to thoroughly explain its exercise procedures, including any deadline your firm may have for exercise instructions on the last trading day before expiration. The exercise settlement values of equity index options are determined by their reporting authorities in a variety of ways. The two most common are:. PM settlement - Exercise settlement values are based on the reported level of the index calculated with the last reported prices of the index's component stocks at the close of market hours on the day of exercise.

AM settlement - Exercise settlement values are based on the reported level of the index calculated with the opening prices of the index's component stocks on the day of exercise. If a particular component security does not open for trading on the day the exercise settlement value is determined, the last reported price of that security is used. Investors should be aware that the exercise settlement value of an index option that is derived from the opening prices of the component securities may not be reported for several hours following the opening of trading in those securities.

A number of updated index levels may be reported at and after the opening before the exercise settlement value is reported. There could be a substantial divergence between those reported index levels and the reported exercise settlement value. Although equity option contracts generally have only American-style expirations, index options can have either American- or European-style. In the case of an American-style option, the holder of the option has the right to exercise it on or at any time before its expiration date.

Otherwise, the option will expire worthless and cease to exist as a financial instrument.

The Option Contract

It follows that the writer of an American-style option can be assigned at any time, either when or before the option expires, although early assignment is not always predictable. A European-style option is one that can only be exercised during a specified period of time prior to its expiration. This period may vary with different classes of index options. Likewise, the writer of a European-style option can be assigned only during this exercise period. The amount of cash received upon exercise of an index option or when it expires depends on the closing value of the underlying index in comparison to the strike price of the index option.

The amount of cash changing hands is called the exercise settlement amount.

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This calculation applies whether the option is exercised before or at its expiration. In the case of a call, if the underlying index value is above the strike price, the holder may exercise the option and receive the exercise settlement amount. For example, with the settlement value of the index reported as The writer of the option would pay the holder this cash amount. In the case of a put, if the underlying index value is below the strike price, the holder may exercise the option and receive the exercise settlement amount.

Equity vs. Index Options

As with equity options, an index option writer wishing to close out his position buys a contract with the same terms in the marketplace. In order to avoid assignment and its inherent obligations, the option writer must buy this contract before the close of the market on any given day to avoid notification of assignment on the next business day. To close out a long position, the purchaser of an index option can either sell the contract in the marketplace or exercise it if profitable to do so.

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Important Note: Options involve risk and are not suitable for all investors. All Rights Reserved. Website not provided by OIC. Content licensed by the Options Industry Council is intended to educate investors about U. Options involve risk and are not suitable for all investors.

For more information, please click here. The articles in this section are provided by The Options Industry Council and is intended for educational purposes only and does not in any way constitute recommendations or advice from SogoTrade,Inc. Accordingly, SogoTrade, Inc. Please note fees, commissions and interest charges should be considered when calculating results of options strategies. Transaction costs may be significant in multi-leg option strategies, including spreads, as they involve multiple commission charges.