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.
Putting pieces together
We have seen two different prices for the OEX so far. The price of the cash settlement was $637.31, and the price of the synthetic OEX stock was $636.35. This difference creates the OEX early exercise opportunity. The greater the disparity between the two prices, the more beneficial it is to exercise early. In this example, the difference in the two prices comes out to be $0.96 ($637.31 – $636.35).
Early exercise arbitrage = cash settlement – synthetic price
Early exercise arbitrage = $637.31 – $636.35
Early exercise arbitrage = $0.96
Note: A positive value indicates a call exercise and a negative value indicates a put exercise.
Revisiting what we have discussed to this point, we see that the cash market closes and settles at 3 p.m. when the New York Stock Exchange closes. On Thursday afternoon, the cash closed at $637.31. The OEX options and S&P 500 futures continued trading for 15 minutes after the 3 p.m. close.
The market then sold off slightly after 3 p.m. for any number of reasons, making the purchase of the OEX more reasonable ($0.96 cheaper) than at 3 p.m. But because we were allowed to exercise our current options up to 4:30 p.m. Central (1 hour, 30 minutes past the cash close), we could trade both the cash and synthetic prices.
Let’s assume that you owned a riskless position known as a “box.” An options box position is the simultaneous ownership of a long call spread and long put spread sharing the same strikes. Another way to look at the box is owning long synthetic stock at one strike and being short synthetic stock at a higher strike. If we were to own the 625-635 box, it would mean that we own the 625-635 call spread and the 635-625 put spread (see “Spread breakdown,” above).
- The first table in “Spread breakdown” shows that we will exercise our long 625 call because it is a call exercise, and it is the only call that is deep in-the-money (ITM).
- Once the call is exercised, it will be closed out at the cash price of $637.31, as shown in the second table. This will change the position dramatically because this call is almost a 100 delta option and the corresponding put (625 put) is almost worthless.
- See the third table. Because the 625 call was exercised and its corresponding put has almost no statistical chance of expiring ITM with only one day remaining, we need not concern ourselves with this strike anymore (for now). Instead, we will have to close out the remaining short synthetic stock at the 635 strike via buying the equivalent amount of short synthetic stock we are exercising. In this example, it is one contract. We will purchase one contract of the 635 call and sell one contract of the 635 put to close out the position. Note: Most traders will trade the most liquid contract, so they will trade the at-the-money strike. It just so happens that the ATM strike was part of the box we had in position. Recall from above that we bought the synthetic stock for $636.35.
- As we can see in the fourth table, after closing out the 635 strike by buying synthetic stock, we noticed that all the positions were gone with the exception of the 625 put. Though it has a small statistical chance of ever being worth anything by the end of the following day (expiration), it should be bought back nonetheless. We do not want to give back all of our profits (and possibly more) simply because we were too cheap to purchase an 18¢ option.
We are now finished with the trade and can phone in our intent to exercise the 625 call to the brokerage firm. Let’s see what kind of profit we made from this trade:
- Sold cash out through exercise at $637.31
- Bought synthetic stock for -$636.35
- Bought 625 strike garbage put for -18¢
- Net profit: 78¢ minus commissions.
We have gone through what appears to be a complicated procedure for a small amount of money, but keep in mind several things:
- The more you practice this, the more intuitive and easy it will become.
- Though 78¢ does not seem like much, it is $78 per contract, so 10 contracts would make you $780 minus commissions.
- This is a net of $780 more than you would have received had you not done anything and simply waited for the entire position to expire at cash the next day. In short, this is as close to free money as you will ever get in trading.
- This is an average exercise, and in volatile conditions, the profits can often be several dollars instead of 78¢. Obviously you will need to work in your commission cost before deciding which early exercise opportunities to exploit.
The difference between a good trader and a great trader often is measured by just a few extra tools in his tool box. The early exercise OEX strategy is a valuable tool that can make a major difference in the bottom line over time.
Ann M. Castaneda is the director of the International Division of RandomWalkTrading.com. Random Walk LLC is a stock and option education company.