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Have you ever traded index options? They are definitely widely promoted throughout the Optionetics community and used by many options traders for both speculative and hedging purposes. However, many traders are not aware of one extremely important distinction that separates index options from stock options. In this article I will focus on the Russell Index to illustrate my point.

The Russell Index trades on the Chicago Board Of Exchange [CBOE] under the symbol RUT. The website defines the Russell 2000 Index as an index designed to measure the performance of the bottom 2,000 companies from a universe of the 3,000 largest stocks in the U.S. 

The CBOE website goes on to explain that the index is capitalization-weighted and includes only common stocks belonging to corporations domiciled in the US and its territories and traded on the NYSE, NASDAQ or the AMEX. The Russell 2000 Indexes are adjusted once per year, in June, to reflect changes in rankings and shares outstanding.

It is important that traders know the exact specifications of the option being traded. This is where the RUT deviates from your common stock option.

Do you know how/what the underlying settlement value is? It isnt the RUT! Many traders were recently caught out by this upon April expiration. The expiration date for the RUT options is the Saturday following the third Friday of the expiration month. This is in line with all US options. However RUT options cease trading on the Thursday before expiration as do all index options that are cash settled.

This means the option ceases trading on the Thursday however the settlement value is not determined until the market opens the following day. Overnight trading from Europe and Asia Pacific will influence the next days opening prices of the Russells constituents. But wait, there is more. The RUT does note settle based on the opening prices of the stocks that make up the RUT. RUT settlement is based on an index that trades under the symbol RLS [CBOE]. The RLS is described as the RUT Flex Opening Exercise Settlement. 

The RLS is calculated by taking the opening price of each of the Russell 2000 stocks. Each day when the market opens all stocks dont start trading at the same time. They are phased in. So the opening price of each RUT constituent is taken and put into the weighting to determine what the RLS value for that day will be.

Due to this fact it is possible for the value of the RLSs value for a particular day to be higher  or lower than the RUT daily bar high/low. This was certainly the case on Friday April 20^th 2007 (April expiration). The RUT closed at 819.32 on Thursday April 19^th, had a opening price of 823.55 and a high of 829.43 on Friday the 20^th. The RLS had a settlement price of 831.41. Figure 1 below displays this with the RLS in purple and RUT in green/red.

Figure 1: RLS & RUT Chart Overlay
Source: ProfitSource

If you were short an April 830 call option you would have been exercised as it expired $1.41 in the money [ITM] and not OTM as the RUT index lead you to believe. Per contract your account would have been debited $141 over the weekend rather than keeping the entire premium from selling the call option.

How is it possible that the value of the highest value of the RUT is less than the RLS opening price? It is due to the fact the RLS is based on the stocks opening price whilst the RUT is based on the Index value at that time. So if all the stocks in the RLS open at their days high and then trade down then the RLS will have a value much higher than the RUT. This is because as more and more stocks open for the day the stocks which have already opened are trading at a lower price and therefore the Index is not as high as if the opening price of each stock is taken individually and used in the calculation.

The topic of conversation in this article will take some solid concentration to understand. To avoid the pitfalls of the RUT options close out your position on the Thursday before expiration. This way you cannot be affected by the RLSs settlement value on the Friday which is calculated the day after the options cease trading.

In Table 1, below, I have included a table that lists the major indices and the underlying settlement value codes. If you trade options on indices you definitely need to be aware of these. All of these symbols are European style and settle in the morning.  

Table 1: Table of Optionable Indices and Their Underlying Settlement Symbols

Guy Halpin
Senior Writer
Optionetics.com
Trading Tutors

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