I have been trading options for over ten years and I confess that I have only truly understood the expiry process on US index options and futures for the past couple of years. While browsing various internet bulletin boards I repeatedly come across confusion about what happens at expiry (or expiration as our US cousins call it) and what and when witching is. Researching the subject only confirmed my view that there is much confusion about the process. The term 'witching' seems to have been coined as a result of the confusion and complication of expiry as well as the volatility of the underlying market that expiry causes. Black magic seems to describe the expiry process, hence witching. Triple witching and more recently quadruple witching are more powerful manifestations in the expiry cauldron.
Witching describes US index expiry. This takes place on the third Friday of the expiration month. So April expiry takes place on the third Friday of April. There are two types of US index options - those based on the cash index, namely the SPX,NDX and DJX, and another set of options based on the quarterly futures on those indices.
On quarterly futures expiry months (March, June, September, and December) all these option types expire in the same way but in serial months (the other eight months) the process is different. It is therefore important to know which type of options you are trading. With the underlying market, you would know what product you are taking a position in but with the spread betters it is not so clear.
Of the three main spread betting companies that trade options, IG Index quotes options on the cash index, while City Index and Cantor Index quote options on the futures. Due to fair value (the premium of the futures over cash) the premiums of these options can be different for the same expiry month and strike price. Also, cash options are European exercise (no early assignment) whereas futures options are American-style exercise (early assignment permitted). Spreadbetting companies do not pass on early exercise and shield the trader from this risk.
Expiry of these options involves the Special Opening Quotation (SOQ) which takes the first trade of each stock in the index and compiles a special value of the index from these first trades. On a regular basis, the SOQ is fixed at a value outside the range of the underlying index. An index will have some issues up and some down and the index value is made up of all of these values at any one moment. The SOQ is just the first trade of each issue so, if a large trading organization wants to push the expiry level up, it only has to make one buy trade for each issue of the index and can then sell the stock immediately afterwards. These first (higher) buy trades are used to make up the SOQ. I think the SOQ is a ridiculous and complex way of deriving a settlement price as it is unhedgeable and open to wild manipulation. Robert Lee, head of the index options desk at City Index said his clients tend to close their US options positions in advance of expiry rather than risk the vagaries of the SOQ.
In futures expiry months, the futures and options cease trading at 4:15pm New York time on the preceding Thursday but the expiry level is determined by the SOQ on expiry Friday morning. During the Friday, US stock options expire also, hence the term 'triple witching'. With the introduction of stock futures, which also expire on the Friday, we now have what is called 'quadruple witching'.
In serial months the process is different. Cash options expire in the same way as in futures expiry months using the SOQ. However, futures options expire at the end of the Friday using the last tick of the future at the Friday close at 4:15pm. This is another reason why cash options and futures options can have different premiums near expiry as the futures options last for another whole day before they expire. Almost as a foot note, US stock options just expire on the closing price of the underlying stock on the Friday. Exchange Traded Funds (ETFs) such as SPY, DIA, and QQQQ also have options available on them but, as the ETFs are stocks, these options are stock options and expire at the end of the expiry Friday.
Settlement of all US index options and futures is in cash, which means there is no delivery of the underlying, even in serial months. Stock options and single stock futures in the underlying markets settle with delivery of the underlying stock. Spreadbetters settle stock options in cash.
European Index Expiry varies by country and has been changed recently in the UK. This article will cover the German Dax 30, the French CAC 40, and the UK FTSE100. All these indexes expire on the third Friday of the month as do the US indices but the expiry method is different. In France, CAC 40 futures& options uses a process similar to the superseded UK method, where the expiry value is the average of all index values calculated and disseminated between 3.40pmand 4pm on the expiry day (including the first index value disseminated after 4pm).
The German Dax 30 expiry level is determined in the intraday auction starting at1pm CET in the electronic trading system Xetra and is a similar process to the creation of the US SOQ. However, I am told that the German expiry is a very orderly and staid affair.
The UK FTSE expiry level determination mechanism changed to an intraday auction method similar to the US and Germany only it takes place between 10.10am and 10.30am.When the new mechanism was first introduced the swings were so wild that the settlement price was some 80 points higher than the FTSE100's high for the day. This prompted an FSA investigation (which did nothing to help those private traders who got burned) that tightened the range of allowed stock prices during the intra-day auction. Although, in my opinion, the intra-day auction is a retrograde step from the average over time method, at least in Europe the determination takes place during the expiry day, giving traders a chance to hedge or close positions just prior to expiry. The US method expose straders to overnight risk and gives no opportunity to close index options prior to the SOQ.
European index options and futures all cash settle. European stock options expire at the closing level for the underlying stock at the end of the expiry Friday.
Asian index expiry has two different methods. I particularly like the Hang Seng index expiry, which takes place on the penultimate trading day of each month and is the average of the quotations of the Hang Seng index taken at five-minute intervals during the expiry day - how sensible and fair.It is easy to hedge and hard to push one way or another. The FTSE/Xinhua China 25 index, which also trades on the Hong Kong exchange expires in exactly the same way. Equity options that trade on the Hong Kongexchange also expire on the day preceding the last day of the month and expire at the closing tick of the day. The Nikkei 225 Japanese index mimics the US system with a special opening quotation.
In conclusion, there is a variety of expiry methods some more benign than others. As atrader of SPX options I find the SOQ method particularly onerous, unfair and outdated in an environment that is supposed to be open and transparent.
by Robin Tracey
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