Question: Is there a way to exploit the early exercise element of the OEX index instead of fearing it?
Answer: Yes, by exploiting the 15-minute trading window in OEX options.
Since its inception in August 1982, the S&P 100 index has been one of the most popular and liquid indexes; however, many people still consider the early exercise component a mystery. Many brokers instill the fear of God in anyone who trades anything but naked long options in the OEX index. The good news is that if you can add and subtract, then you can thrive in the OEX during the early exercise process.
When you own an OEX call (or put), you also have an embedded free call (or put) in that option. The OEX index is a cash-settled index that derives its price from the largest 100 stocks that close at 4:00 p.m. (EST). Yet, the OEX options market stays open 15 minutes longer, until the close of the S&P 500 index at 4:15 p.m. This 15 minutes opens a whole wonderful world of opportunities for an OEX option owner.
Think about it. How often does news come out right after the NYSE closes? Many companies announce their earnings right after the New York close yet before 4:15 p.m. The cash markets have stopped moving, but the option markets still are open — opportunity exists in this period. The options will continue to move off of the S&P 500 futures, yet they can be exercised at the cash price. It almost sounds illegal.
Suppose that earnings in IBM come out at 4:04 p.m. and they are horrific. In after-market-hours, the world sees that IBM is going to open $20 lower the next morning. This equates to 140 points in the Dow Jones Industrial Index (DJIA). The S&P futures will reflect the bad news and immediately trade lower by a corroborating amount. But remember the OEX cash stopped moving at 4:00 and will not reflect the new price until the next day’s open.
The following process works with call or puts (the puts in reverse), but we will focus only on calls.
After the hypothetical IBM news came out, the S&P futures would fall and the OEX options would move as well. The cash settled at $582. The option chain at 4:10 p.m. looked as follows:
The math is very straightforward. Because there is no OEX future or ETF, one has to create a synthetic stock price via options. It doesn’t matter which strike one uses to calculate this, but most people use what will be closest to the at-the-money strike. The formula is as follows:
Here we see that the synthetic stock is trading at $576.75 and the cash settled at $582, a difference of $5.25. Because the synthetic is lower than the cash, it is a call exercise. If the synthetic were higher than the cash, it would be a put exercise.
If we are long 10 contracts of the 565-580 call spreads, we have an in-the-money call we can exercise. By exercising the 565 strike call, this option closes out at the cash settlement price of $582.
Long 565 call: By exercising our long 565 call when the cash settles at $582, we collect the difference between the call and the cash price, or $17.
Short 580 call: Because we had a long call spread, we also will be short the 580 call naked after the exercise. This is not a favorable position, if for no other reason than margins. We look at the option chain and see that we can buy this back for $1.50.
If we sell our long call in the exercise for $17 and we buy back our short call in the marketplace for $1.50, then we are receiving $15.50. In essence, we are selling out our long $15 wide call spread (565-580) at $15.50 - $0.50, more than the maximum we could hope to make.
To make this even more appetizing, look at the prices of the options and see what the spread is trading at if you do not exercise your long call. You can see from the option chain that the 565 call is trading at $13 and the 580 call is trading at $1.50, thus the call spread really only is trading at $11.50.
By knowing how the exercise works, you made an additional $4 on your 10 spreads, or $4,000.
So why are people afraid of the OEX exercise? People fear what they don’t understand. Here, we have provided a remedial overview of the process. Hopefully, the information was enough to eradicate your fear and foster your curiosity for further learning.
Susan Steward is chief economist for RandomWalkTrading.com, an options education company comprised of retired CBOE floor members.