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In last week’s Interactive Technical Trading [ITT] Class held in Singapore, half of the class expressed interest in trading RUT 2000 Index options (RUT). Is it because of Mike Wade’s influence, or perhaps mine? I don’t know. Anyway, I enjoyed the ITT Class a lot and learnt something, too, from my fellow colleagues and the students.

As promised to the class, this article is specifically devoted to a common problem associated with trading index options – that is, how such index options are settled at expiration. Very often, I’ve heard from students who want to start trading index options that they have absolutely no clue about the settlement process for such index options. So, I am going to discuss this issue, specifically in respect of RUT, since I am using it for my Big-Mouth-Iron-Condor [BMIC] System.

My First, Important Message

The first point I would like to make is before you embark on trading any index options, please make an effort to understand the product specifications. Don’t assume that index options settle in the same way as equity options. Making such assumption can put your entire account in jeopardy and I have heard enough such stories over the past few years. The most horrible one I ever heard of is about an experienced trader who lost 10 months of his profits in trading an iron condor in just 1 second. Someone may ask if that was me. Actually, it was not me as I understood this process for more than 3 years before I started trading index options.

So, where do you look for the product specifications for RUT options? It can be found in the CBOE website at www.cboe.com. Please do yourself a favor by making a genuine attempt to understand what is said there before you trade RUT options with real money. Notwithstanding this, let me share with my readers some of the key points.

European-style Options

Recently, there was a very popular topic regarding early assignment of options in the Optionetics discussion board. In case you are confused with the discussion, that’s fine. You may be pleased to note that such issue will not happen on RUT options because they are European-style index options, meaning that the early assignment issue does not exist. Some traders I know prefer to deal with European-style options because they don’t need to worry about the early assignment issue. That’s fine.

Last Trading Day 

You need to know that the last trading day for the current month’s RUT options falls on the third Thursday of that month. For example, the last trading day for Feb08 RUT options was Feb 14, 2008. This is unlike other equity options whose last trading day falls on the third Friday of that month. What this means is that if you have a position involving current month’s RUT option, you need to decide how you want to deal with it before the end of the third Thursday of that month.

Settlement Value – RLS

The settlement value of RUT options is RLS (RLS). How is RLS determined? In a nutshell, RLS is based on the opening prices on the third Friday of the current month for all RUT component stocks. Once the opening prices for all component stocks have been established, the value of RLS can be determined. Of course, you should look at the product specification again because it contains the tie-breaker clause to deal with situations where, for example, one or more of the component stocks are halted for trading on the third Friday of the current month. This is beyond the scope of this article. In any case, under normal circumstances, the value of RLS should be available to the public towards the end of the third Friday of the month. For traders like we who live in Asia, we should know the value of RLS when we wake up on Saturday morning.

The following is an extract of the value of RLS from Jan 2007 to Feb 2008. I have also listed the closing price on the third Thursday and the opening price on the third Friday for RUT options for comparison purposes (Table 1):

Table 1
Source: CBOE website

From Table 1, perhaps you will notice that over the past 14 months, there were 4 times when the value of RLS exceeded the closing price on the third Thursday by more than one strike (i.e. more than 10 points). This occurred in Apr 2007, Jun 2007, Aug 2007 and Dec 2007. The question is, why did such an event occur? It may occur due to the US economic data to be released before the market on the third Friday of that month is open. It may be due to some news around the globe overnight. Again, remember what Tom Gentile said in his 7 habits – the US market is one of the most inefficient markets in the world. This is exactly the situation. It is liquid between 9:30am and 4:00pm EST but news continues flowing around the globe beyond this period. In our case, we are not able to deal with our RUT options on the third Friday, no matter what happens to the US stock market, because these options have already ceased trading on the third Thursday.

A Hypothetical Example

Suppose our dear friend Bok sold an Aug07 790-800 call spread. Based on the closing price on the third Thursday, Bok thought that his trade should be safe as it would be hard to believe that RUT could gap up by more than two strikes on the third Friday. So, when the market opened on the third Friday, the opening price was 774.40 and Bok might have thought that his call spread would expire worthless, and he could happily keep the credit. This is the danger I have been talking about. If Bok does not understand the settlement process, he may not even know that he has hit the maximum risk until after Friday. He may also call his broker, screaming and shouting at the poor chap for making such stupid mistake and messing up his account.

To me, it is not surprising at all. Bok should have blamed himself for not knowing how RUT options work. I checked the end-of-day data using Platinum, and I noted that the spread could be bought back for approximately $0.80, based on the third Thursday closing price, which is a dime above the mid-point of the call spread. See, Bok could have paid $0.80 to keep the rest of the credit rather than hitting the maximum loss if he would have understood how RUT options and the settlement issue work.

Now you should understand why I insist on putting a good-till-cancel [GTC] order to buy back the call and put spreads for 10 cents to 20 cents in my BMIC system, and demand a hard close before the end of the third Thursday if the GTC order fails to execute.

I hope I will not hear any sad stories of the same nature in the near future. But who knows? There are always people around who will surprise us. That’s the fun I get in this market.


Jack Wong 
Staff Writer
Optionetics.com ~ Your Options Education Site

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