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Examining the issues around AM/PM settlement of indexes



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Before we go into the details of AM/PM stock options a brief introduction into index options is mandatory.

In trading, index options are often the best, simply because they are oftentimes more liquid than stock options. It is also interesting to note that the index price movements are less mercurial than their component stocks and hence more interesting for market neutral tactics.

There are three core distinctions in index options and they are options that can be settled in cash or stock, the American or European style exercises and AM or PM settlement.

The first one is rather straight forward and means that when an option is exercised, one gets a cash or stock position. We will not get into the details of this now.

American or European exercise refers to the opportunity to exercise a long index option before it expires. The difference between the two being that the American option is flexible to exercise from the time the option is bought until it expires. European on the other hand, can only be exercised at expiration and never before. Again we will not get into the details of this index option.

The third distinction which we will discuss in further detail is also the most confusing and is the am/ pm settlement. What it refers to is the time of the determination of final settlement for cash settled index at expiration. It has an AM settlement when the price settled is determined on the opening trades of the stocks. This typically happens on Friday morning of expiration of the option and thus is coined the term AM settlement. When the settlement, on the other hand, happens on the closing stocks in the index, it is said to be a PM settlement. This typically happens on Friday afternoon of expiration.

In general, PM settlement is easier to comprehend because it works just like stock options do. At the time of expiration, one looks at the index price to see if the option is in the money or not. But with AM settlement trading actually stops the day before. So, if positions are not closed out, there is a risk of a move in index between the close of the previous day and the final settlement price the following morning.

The SPX, is has an AM settlement and is subject to the risk of what AM settlements come with. Most often there are no huge moves between Thursday afternoon and Friday morning but in the rare case that there are it can cause a bad dent. There are also problems with the OEX, S&P and SOX Index options. These are American style options and it is suggested that one stays away from OEX, and stick with XEO, which are the European style S&P index options. There is no early exercise risk in the XEO and this is precisely why there are not many American style cash settled index options.

 

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