Cash vs. Non Cash Indices

[deltahedge]

Hey all,

I read somewhere that novice option traders if they want to do indicies they're initially better off using non cash indicies on vertical spreads. If on you're short (call or put) position you're exercised (that night) and prior to the market opening some catastrophic event occurs and the market gaps down you're screwed if you used the cash indicies (i.e. OEX, SPX) as the corresponding cash value of the index is netted against the strike amount and the difference is paid to the option buyer. However, he said if you used an ETF which tracks an index (i.e. SPY) when you're exercised you effectively become short the stock while you still have the other leg of your spread intact.

Am I missing something here or what?

If you have other advantages/disadvantages of using cash and non-cash indicies would love to hear it

p.s. I'm confused since I thought early exercise on cash settled indicies rarely occurs?

 

[steveplace]

SPX options are european, which means you can't get early assignment. Also, regardless of the style, if you're in a spread, the max loss is locked in as you are an option buyer on a different strike.

There's other tradeoffs such as size and liquidity when considering what to trade, but I don't think this is a true issue.

 

[MTE]

There's no such thing as non-cash settled indices. All index options are cash-settled. What you are referring to is European vs American-style options.

The problem you are describing is the problem when trading OEX options, which has American-style options that can be exercised at any time and since they are cash-settled you may end up with a naked position.

SPX and pretty much all other indices are European-style, which, as it has been pointed out in the previous post, cannot be exercised early and thus you don't have a problem of getting assigned early due to a gap in the market.

 

[MTE]

Quote from steveplace:

...Also, regardless of the style, if you're in a spread, the max loss is locked in as you are an option buyer on a different strike...

This is not correct. If you have a short vertical spread in OEX (American-style index options), and you are assigned on a short then your loss is NOT limited to the difference in strikes. The reason being that your short assignment would be marked against one settlement price, while the consequent long exercise would be marked against a different (the next day's) settlement price.

The problem is precisely because of the cash settlement. This is not a problem when you have physical settlement in shares.

 

[steveplace]

Quote from MTE:

This is not correct. If you have a short vertical spread in OEX (American-style index options), and you are assigned on a short then your loss is NOT limited to the difference in strikes. The reason being that your short assignment would be marked against one settlement price, while the consequent long exercise would be marked against a different (the next day's) settlement price.

The problem is precisely because of the cash settlement. This is not a problem when you have physical settlement in shares.

You're right, but on a technicality. For other indicies if you're assigned early, flip out of the stock and reenter your position. But since OEX is a different animal, you do have that risk of a day gap before/after.

However, I feel that the odds of that incident occurring are quite low unless your option is trading at parity.

 

[dagnyt]

Quote from deltahedge:

Hey all,

I read somewhere that novice option traders if they want to do indicies they're initially better off using non cash indicies on vertical spreads.

Avoid this problem by not trading OEX options.

SPX, NDX, RUT, XEO are all European style and there is NO chance of being assigned early.

Mark

 

[MTE]

Quote from steveplace:

You're right, but on a technicality. For other indicies if you're assigned early, flip out of the stock and reenter your position. But since OEX is a different animal, you do have that risk of a day gap before/after.

However, I feel that the odds of that incident occurring are quite low unless your option is trading at parity.

No, all index options are cash-settled so you cannot flip out of the stock position as there's no stock position, besides most if not all other index options are European-style.

 

[christianhgross]

Quote from MTE:

There's no such thing as non-cash settled indices. All index options are cash-settled. What you are referring to is European vs American-style options.

SPX and NDX are cash settled indicies. However, I think ES and NQ are futures based indicies. NQ and ES are American, and if you are assigned you get the futures contract. That can be good or bad, depending on the underlying futures contract.

You need to be careful when playing the ES vs SPX vs SPY because the prices are not the same.

 

[steveplace]

Quote from MTE:

No, all index options are cash-settled so you cannot flip out of the stock position as there's no stock position, besides most if not all other index options are European-style.

I misspoke. By "other" I was referring to tradeable etfs such as SPY QQQQ IWM.

That is an interesting point that you bring up with respect to the OEX options, but that seems to be the exception rather than the rule, am I correct in saying so?

 

[MTE]

Quote from christianhgross:

SPX and NDX are cash settled indicies. However, I think ES and NQ are futures based indicies. NQ and ES are American, and if you are assigned you get the futures contract. That can be good or bad, depending on the underlying futures contract.

You need to be careful when playing the ES vs SPX vs SPY because the prices are not the same.

ES and NQ are futures contracts based on indices, they are not indices. I agree it's more or less semantics, but for a newbie it can very confusing so everyone should try to use the correct terminology.