Tuesday, December 1, 2015

Cash Settled and Equity Settled Explanations

Let's take an example of a recent trade I made where I got assigned the underlying.
Mid year I played a CSIQ short strangle for 5 contracts.The short put at 21$.

CSIQ went down to around 17$ over the week and I got assigned the stock.

Now I had to buy the stock for 21$/share , 500 shares = $10500 whereas the stock was worth only 17$, leaving me with a loss of 2000$.
I had to use my capital for stock, locking up the capital and leaving it to the fluctuations of the market.

Now let's compare this to a cash settled index play.

SPX 2000/1995 Bull put, assume that SPX is at 1995 at close, and let's assume we have the same 5 contracts.

You are long 1995P and short 2000P,  therefore one's ATM and the other is ITM.
Upon exercise and assignment here's what happens;

(1995-2000) x 5 x 100 =-2500$ , the brokerage will deduct 2500$ from your account and some additional fees.

The additional concern here is that since option contract closes on Thursday , yet settlement prices are calculated on Friday, a lot could happen on a Friday and you'd open yourself to a lot of risk.
Due to this very technicality time value on SPX and other indexes continues into expiration.

Take this example - say you are -1 contract on a 2000P on the SPX expiring on Friday. It is Thursday today and SPX is hovering at around 2005, you are 5$ OTM.
You decide not to close the option and keep it open, on Friday it opens at 2004, but the settlement is priced at 1998 since it can potentially take all morning into afternoon to calculate settlement prices.
Now you are in trouble as your short option is ITM, your cost is now (1998-2000)x100 i.e. 200$ per contract.
Furthermore you are helpless as you cannot trade the option on Friday, last day of trading was Thursday..

So whats the best strategy, probably to close out on Thursday - take profits,eat the loss or roll if at all possible and move on.

Key points to look at prior to making the trade:
1) Look at 1 σ at the least, 2 σ at best.
2) Look at the 10 day moving average.
3) Stocks and indexes cant just keep going up, pullback is inevitable look for 2-3 day moves and for reversals.