ITM Option Settlement Review

• Index Settlements:– European Style Options: buyer cannot exercise the contract early.– Cash Settled: if contract is ITM and assigned – there are no shares to buy and sell so

money goes from the options seller to the option buyer.– Standard Monthly Contract Expiration (third Friday): Thursday expiration but Friday settlement.

– Non-Standard Expiration (all other contracts other than the Standard Monthly Contract): expiration and settlement are on the same day.

• Equities/ETFs:– American Style Options: buyer has the right to exercise the option contract early.– Settlement process involves shares changing hands between the option buyer and

seller. Which way the shares go depends on if it is a PUT or a CALL.– Expiration and Settlement are at the end of the last trading day of the contract.

http://www.cboe.com - Products Page for more information

RUT ITM Settlement

• If we allow a RUT credit spread to expire ITM (mistake!):– Our broker does EXACTLY what we told them to do when

we sold and/or bought the option contracts.– If we know what the obligations and rights are of an

option contract, then we will know what can happen.– BUT LET’S REVIEW:– If the short strike is ITM and the long strike is OTM, the

broker withdraws the difference between our short strike and the RUT settlement price from our account.

– If both strikes are ITM, we incur our maximum loss: the spread between short and long strike.

ITM Credit Spread on a Stock/ETF

An ITM stock or ETF is treated differently than an Index:

* Shares are exchanged at assignment and if we sold a PUT, we automatically pay the strike price for the shares.

* But we do NOT want shares of the company or ETF that we did the credit spread on.

* We will want to immediately sell the shares because we don’t want to hold on to a company that is not Wonderful or that we paid too much for.

* If we don’t have the money to buy the shares, our broker will automatically sell the shares.

* If we do have the money, they will take the money we promised to pay and then give us the shares. We have to sell the shares quickly or we could take an even bigger loss than the spread of our credit spread because the stock price could go down from where we bought it.

* Either way, our loss will be the difference between what we paid (the strike price) and the stock price when we managed to sell it.

Equity ITM Settlement

• If we allow our credit spread option contracts to expire and settle with the underlying equity price below both our short and long strikes:– Both strikes automatically exercised/assigned– Results in cash loss equal to the spread

• What if the price settles in between the strikes?– Short strike automatically exercised– Long strike expires worthless– Result: we own shares of the underlying security at our short strike price.

Oops! Don’t want that or we would have done a ROP. – We will lose the difference between the strike price we paid for the

shares and price we were able to sell the shares at.– If the assignment happened at contract expiration on a Friday, this usually

takes place on Monday morning.

Equity ITM Settlement on a Credit Spread

• Amazon closed (settled) at $2675.01• Short strike automatically exercised:

buy 500 shares at $2,685 = $1,342,500• Long strike expires worthless

Equity ITM CS Settlement Example

Example of how scary numbers can result:• ITM options at expiration are

automatically assigned.• Occurs during the weekend.• Resulted in negative cash

balance.• We now own shares we don’t

want and maybe can’t afford!

Equity ITM CS Settlement

• With a negative cash balance, our broker may or may not sell the shares for us at the market open on Monday. It is their choice.

• We need to confirm with our broker how OUR broker will handle this situation in OUR account.

• Whether or not our broker sells the shares for us, there is risk of the price dropping between the close Friday and the open Monday.

• We bear 100% of that risk.• DO NOT PUT YOURSELF IN THIS SITUATION: – Stay in the “box” - FOLLOW THE RULES – WE NEVER ALLOW OUR CREDIT SPREAD TO BE ITM