Settlement and the resulting transfer of cash generally occur on the next business day after exercise. Note: Many 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 explain its exercise procedures thoroughly, including any deadline for exercise instructions on the last trading day before expiration. Reporting authorities determine the exercise settlement values of equity index options in a variety of ways.
The two most common are:. 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. When the exercise settlement value of an index option is derived from the opening prices of the component securities, investors should be aware that value might 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 exercise, 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 any business day before its expiration date. The writer of an American-style option can be assigned at any time, either when or before the option expires.
Early assignment is not always predictable. An investor can only exercise a European-style option during a specified period prior to expiration. This period varies 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 at expiration 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. 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 pays 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. 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 potential 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. Equity vs. Index Options An equity index option is a security which is intangible and whose underlying instrument is composed of equities: an equity index.
The price of an index call generally increases as the level of its underlying index increases. Its purchaser has unlimited profit potential tied to the strength of these increases. The price of an index put generally increases as the level of its underlying index decreases. This is the last day that the option contract is trading on the exchange.
The holder can choose to close the position or to let the contract expire. As index options are cash-settled, the investor receives or pays cash, depending on whether the option still has value when it expires. At expiry, the issuing exchange determines whether there is a remaining value. If there is any, this is paid out to the investor. In finance, derivatives have an underlying value. This can be an index, basket of assets, or even another derivative. It goes without saying that the underlying of an index option is an index.
The price of an option is affected by several variables. These are the current stock price, the intrinsic value, implied volatility, interest rates, cash dividends paid, the type of option, and the time to expiration or the time value.
The closer the option comes to maturity, the lower the time value will be. When you buy an option, you open a long position. For this position, you pay a premium.
The number of units of the underlying that is covered by a single option contract is usually set by a multiplier. Depending on the option series, there can be daily, weekly, monthly and quarterly options. The contract size is the value by which the underlying is multiplied in order to determine the premium. On top of the premium, it is also possible that you have to pay broker fees.
These depend on the broker and can usually be found in the fee schedule or on the website of the broker.
Usually, the broker also charges transactions costs for index options, which can also be found in the fee schedule of the broker. As mentioned earlier, index options are cash-settled since the underlying the index cannot be physically delivered. Investors that have long positions in an index call option that still have value on the expiry date, will automatically receive a cash settlement.
Investors that have short positions in an index call option that still has value on the expiry date, have to then pay this cash amount. When the index option does not have any value at expiry, it is automatically booked out of your portfolio against a value of zero. In this case, there will not be a cash settlement. Index options are typically used by investors who can bear the loss of capital and have sufficient knowledge of similar financial instruments.
Generally, investors that invest in the products have a relatively short investment horizon shorter than five years.
Some index options are considered riskier than others. All index options should have a KID. This is a 3-page document which describes the characteristics of the products and risks associated with the product. Apart from the KID, information about contract specifications and the underlying can usually be found on the exchange website.
The symbol of an option refers to the underlying of the option. For practical purposes, index options are generally cash-settled options. This makes sense as you can imagine the hassle involved in transferring hundreds of underlying stocks during an assignment, not to mention the enormous amounts of fees involved. Hence, only the representative amount in cash changes hands when cash-settled index options are exercised. The amount payable by the index option contract writer is known as the exercise settlement amount and is defined as:.
As can be seen from the above formula, the main determinant of the exercise settlement value is the index value which is primarily affected by the prices of the underlying securites. To a lesser extent, the index value is also influenced by the index option's settlement style. Depending on the settlement style of the index option, the reported level of the index may differ materially when the option is exercised. Consequently, this affects the exercise settlement value.
The two most common settlement styles are A. With AM settlement, the index value is calculated based on the opening prices of the index's component securities on the day of exercise. With PM settlement, the index value is calculated based on the closing prices of the index's component securities on the day of exercise.
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