This is the time of year when we begin to see a myriad of articles about the year in perspective. Let me start the wave with some observations about the 2016 settlement prices for the Standard and Poors 500 Index, SPX. As you may know, the last time one may trade SPX options is on the Thursday of expiration week. But SPX options do not settle at the closing prices on Thursday or Friday of expiration week. A special settlement price is determined on Friday morning, based on the opening price of each of the 500 companies that make up the index. I have been keeping a spreadsheet of the settlement prices for the Russell 2000 Index and the Standard and Poors 500 Index since 2006. You may download a copy of the spreadsheet in the free downloads section of my website.
Why would I keep updating this spreadsheet every month for eleven years? I have been trading iron condor spreads on the broad market indices since 2004. One of the reoccurring questions facing me over these years has been: Is it safe to allow these options to enter expiration and expire worthless, or should I close them now? As an empirical attempt to answer this question, I started keeping this spreadsheet, comparing the closing price on Thursday of expiration week with the settlement price determined sometime on Friday (usually by noon for SPX, but a couple hours after Friday's close for Russell). A key question for index option traders on Thursday of expiration week is how far might the index move between Thursday's close and settlement on Friday? The average of the difference between Thursday's close and the settlement price is $8.09 for SPX over the eleven years of 2006 through 2016. The range of movement is from a low of $3.68 in 2013 to a high of $14.82 in 2008. The third highest average occurred this year at $10.01. So it wasn't just your imagination, it was a volatile year in the markets. Therefore, the empirical answer is pretty simple. If your short SPX option is less than ten dollars from expiring in the money on Thursday of expiration week, you would be well advised to close it while you can on Thursday. By the way, if you repeat this calculation summary with percentages to account for the growth of the indices, the highest and lowest years don't change, but 2016 is closer to the eleven year average.
Of course, that answer of ten dollars as a guideline is a very rough approximation. The most accurate method would be to compute the standard deviation of the option expiring in the money. Higher values of implied volatility lead to larger values of the standard deviation and therefore higher probabilities of the index moving far enough between Thursday's close and settlement to result in your short option being in the money. Let's look at a couple of examples from this year. The low volatility example is from December expiration. SPX closed at $2262 on Thursday, 12/15 and the volatility index (VIX) for SPX was 12.8%. The standard deviation for one day's price move may be computed as $15. The probability of having less than a two standard deviation move is about 95%. Therefore, if our option's strike price was over $30 out of the money, we had a 95% probability of the option remaining out of the money at settlement. January expiration came during the correction this year, so volatility was much higher. On the Thursday before January expiration (1/14), SPX closed at $1922 and VIX was 23.95%. This results in an one-day standard deviation of $24. In January our option's strike price would have to be at least $48 out of the money to allow it to enter expiration with a 95% probability of expiring worthless.
This illustrates why I formulated my "Two Sigma Rule" for closing index spreads in advance of expiration. On the Friday before expiration week, I calculate one standard deviation (one sigma). If the short option of either of my spreads is less than two sigma out of the money, I close the spread. Consequently, I have never been surprised by a short option expiring in the money at expiration. If you choose to carry your index option position to the Thursday of expiration week, the ten dollar guideline is a "quick and dirty" approximation, but calculating the standard deviation and using the Two Sigma Rule would be safer.
