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May 2, 2014

Understanding Settlement

One topic that is probably not discussed enough when learning to trade options is that of the various settlement issues. Many option traders limit their universe of option trading to two broad categories of underlyings. One group consists of individual equities and the similar group of exchange traded funds (ETFs). The other group is composed of a multitude of broad based index products. These two groups are not entirely mutually exclusive since a number of very similar products exist in both categories, for example the broad based SPX index and its corresponding ETF, the SPY.

The first category, the individual equities and ETFs, trade until the close of market on the third Friday of each month for the monthly series contracts. These days there are more and more ETFs and equities that also have weekly settlements too. These contracts are of American type and as such can be exercised by the owner of the contracts for any reason whatsoever at any time until their expiration. If the contract is in-the-money at expiration by just one cent, clearing firms will also exercise these automatically for the owners unless specifically instructed not to do so in many cases. The settlement price against which these decisions are made is the price of the underlying at the close of the life of the option contract.

When this first group we are discussing settles, it is by the act of buying or selling shares of the underlying equity/ETF at the particular strike price. As such, the trader owning a long call will acquire a long position in the underlying and the owner of a put a short position. Conversely, the trader short these options will incur the offsetting action in his account. Obviously, existing additional positions in the equity/ETF itself may result in different final net positions.

The second category, the broad based index underlyings, are also termed “cash settled index options”. This category would include a number of indices, for example RUT and SPX. As the name implies, these series settle by movement of cash into and out of the trader’s account. The last day to trade these options is the Thursday before the third Friday; they settle at prices determined during that Friday morning. Like ETFs and equities, these index options also have weekly settlements as well.

One critically important fact with which the trader needs to be familiar with is the unusual method of determining the settlement price of many of the underlyings; it is NOT the same as settlement described above. Settlement for this category of underlyings has the following two characteristics important for the trader to understand: 1.The settlement value is a calculated value published by the exchange and is determined from a calculation of the Friday opening prices of the various individual equities, and 2. This value has no obligate relationship to the Thursday closing value for the underlying.

Many option traders choose never to allow settlement for the options they hold, either long or short. For those who do allow positions to settle, careful evaluation of the potential impact on capital requirements of the account must be a routinely monitored to avoid any surprises.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

June 13, 2013

Moving Averages, Volatility and the Man of Steel

We’ve identified a recurring pattern in the market that could end up being one of the best market predictors yet.

Take a look at a daily candle chart of the S&P 500 (or the SPY ETF) for the past 12 months overlaid with the 50-day moving average. As you can see, the index has been in a solid up trend for the past year. There were six pullbacks during just the last six months alone where the SPY pulled back down to the 50-day moving average and bounced higher to continue its assent. It has been a tried and true support line.

But as far as support lines go, moving averages are pretty weak in representing actual trade information—compared to a horizontal support line at a specific price. A horizontal support line shows where the buy orders have been in the past for value investors. For example, if a stock dipped down to $50 a share several times in the past, then rose back up, it shows that that level ($50 a share) is where the demand pressure is—value investors bought the stock at $50 which forced the price back higher.

But, moving average support lines are merely psychological. Because the line is not at a constant price, it doesn’t represent a price where demand occurs. Traders only buy it there because it is a moving average. It’s essentially a self-fulfilling prophecy.

In the case of the market today, one of two things can happen technically over the next few days. 1) Support at the 50-day moving average will hold once again and the SPY will continue higher, or 2) Support at the 50-day moving average will not hold and the SPY will continue lower.

But if the SPY ends up closing below the 50-day moving average, we could see a free fall similar to the eight-percent drop we saw in October of last year when the 50-day moving average did not hold.

This potential drop is compounded by the fact that we’re seeing the implied volatility of the S&P 500, or the VIX, illustrating investors’ jitters. The VIX above 18 says the market is scared. Even the Man of Steel himself (Ben Bernanke of course) won’t be able to keep the market up as he has thus far this year if the levy breaks.

So, we need to sit and wait. I think any move resulting in a close below the 50-day moving average warrants strong selling. But a bounce higher from here probably means more of the same. Up, up and away!

Dan Passarelli

CEO

Market Taker Mentoring