From the May 01, 2012 issue of Futures Magazine • Subscribe!

Trading early exercise options on the OEX index

It’s never too early for (OEX) exercise

Even though the S&P 100 Option Exchange Index (OEX) early exercise is not the sexiest trade, it has drawn a considerable amount of interest. Here, we’ll use a real-world example as a realistic illustration of an average exercise compartmentalized into information packets.

There are four pieces to this process that must be addressed: Cash markets, the last 15 minutes of trading (3 p.m. to 3:15 p.m. Central), OEX synthetic stocks and the option tails. 

Cash markets: The key to understanding this strategy is determining the various times at which different markets close for the day. The OEX is an index based on the Standard & Poor’s 100, a basket of the highest capitalized U.S. companies. To calculate what is referred to as the “cash” value of the index, a cap-weighted formula is used by incorporating the price of all 100 shares comprising the index.

Because the value is based on the price of all the shares in the basket, the cash value stops moving when the NYSE closes at 4 p.m. Eastern/3 p.m. Central. This is the key because other markets involved in this trade continue to trade for another 15 minutes, or until 3:15 p.m. Central.

Let’s walk through an example. On Thursday, March 15, the OEX cash closed at $637.31 at 3 p.m. It could not move again until the next day’s open. That is when the 15-minute clock started ticking on the OEX early exercise opportunity. We will take a snapshot of this:

OEX cash closes (3 p.m.):  $637.31

Last 15 minutes: From 3 p.m. to 3:15 p.m., S&P 500 futures and OEX options still were open, and would move based on current news, and supply and demand. During earnings season, the markets often will make considerable moves after stocks close at 3 p.m.; this is when many companies announce earnings that surprise the markets. Who knows what caused the markets to move that Thursday after 3 p.m.? It doesn’t matter, but they did ever so slightly.

The OEX options (even though the cash is closed) and the S&P 500 futures will keep trading. Because there is a high correlation between the S&P 500 (both SPX and S&P 500 futures) and the S&P 100 (OEX), the OEX options will move depending on what the S&P futures do. If the S&P futures move plus or minus 1% after 3 p.m., so would the OEX cash if it were open. The OEX options will trade as if the index cash still were open, so the second ingredient to this trade is the OEX synthetic. 

OEX synthetic: The OEX is not an exchange-traded fund with shares or a listed futures contract; therefore, if you have a position you want to hedge in the OEX, you will have to do so with options. Instead of using shares of an OEX stock that do not exist, traders can create synthetic stock. The correct combination of calls and puts mimics stock almost exactly. Combining a long call and a short put in the same month and at the same strike will create synthetic long stock, and the reverse creates short synthetic stock. The formulas are as follows: 

Synthetic short stock = short call – long put + strike
Synthetic long stock = long call – short put + strike

The closing prices of the March options one day prior to expiration indicate that the synthetic long (and short) stock price was $636.35 on Thursday’s close, as follows:

Synthetic short stock = $2.50 – $1.15 + 635
Synthetic long stock = $2.50 – $1.15 + 635

“Synthetic positions” (below) graphs OEX synthetic long and short stock trading at $636.35.

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