From the August 01, 2011 issue of Futures Magazine • Subscribe!

Exploiting the early exercise element of the OEX index

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:

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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:

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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.

The exercise

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.

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