Exercise and Expiration Rules

Unlike stock options, which contain standardized terms for all listed companies, the rules for index options will vary based on the exchange and on the publisher requirements and rules determined when the index was created.

The trading size of an index option is not uniform either, as it is with stock options. With stocks, each option is related specifically to 100 shares of the underlying stock. Index options are valued based on the value of the index, times a multiplier.

This is usually $100, but not always; so before comparing prices of index options, check to ensure that multipliers are uniform among the various indices being followed.

Upon exercise of an index option, the holder does not receive a proportionate number of shares in each of the companies listed in the index. Instead, cash is exchanged based on the option value at the time of exercise. Accordingly, index options cannot be used for any strategy involving contingent purchase or sale of stock, a popular reason for employing stock-based individual options. This procedure is called cash settlement. One of the well-understood contractual rights for purchasers of stock options is the right to purchase 100 shares of stock (by exercising a call) or to sell 100 shares of stock (by exercising a put). That right does not exist for buyers of index options. The underlying security—the index value—is intangible, whereas the underlying value of a stock-based option—100 shares of stock—is tangible. This is what defines the difference in settlement procedures.

Exercise procedures are also different for index options. You can exercise your stock-based options at any time before expiration simply by entering an order, and this is usually executed immediately. But with an index option, you are required to notify your broker before a specified exercise cutoff time. This time for early exercise is not always identical for exercise on expiration day. It is crucial for an index options trader to determine the rules of exercise and to ensure that the applicable cutoff times are known in advance and observed. The cutoff deadline for index options often is not the same as the time for stock-based options.

When the holder of an index option exercises, assignment is made to a writer, who is then required to pay cash for the specified exercise value of the option. The procedure is the same as that for exercise of an option with stock as the underlying; but instead of delivering shares, the writer is required to settle in cash.

The timing of exercise will also rely on how the settlement value is calculated. Some index valuation is based on PM settlement, or the value of the index components at the close of a trading day. Many others are based on AM settlement, or valuation of the index components based on a trading day's opening prices.

If an index is traded on American-style expiration, traders can exercise at any time on or before expiration. However, many indices are traded using European-style rules. This means that options can be exercised only during a specified and limited time period, and the period varies for each index. A capped-style rule, much like European style, may also limit the window when exercise is allowed for index options. In any of these situations, traders are allowed to close out their positions before expiration to avoid exercise, take profits, or avoid further losses.

By Michael C. Thomsett
Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.

Copyrighted 2016. Content published with author's permission.

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