Eliminate Assignment and Exercise Risk with Index Options
Traders have significantly more variables to account for when trading options over stocks. As an equity investor, only the fluctuation of the underlying affects the profit and loss of a position. However, with options, the underlying price, volatility, time, and even expiration and assignment risks need to be accounted for. In this post we will explore the significant advantage of trading index option that is embedded in the European-style cash settlement process. Eliminating a low probability but potentially severe risk of assignment and exercise risk can lead investors to a shorter learning curve and more consistent results. Additionally, with the launch of the XND, the Nasdaq-100 Micro Index Option, investors can now access the full benefits of Index options in a retail-friendly size.
European Style Cash Settlement vs. American Style Physical Delivery
Why are European Cash Settled options an advantage for traders?
One of the major challenges of options trading is tracking the fluctuations in the underlying security, time, volatility, and interest rates that impact an option's price. These variables already present a challenge for many investors to monitor and account for all of them. However, assignment and exercise risk pose additional headaches for American Style equity options, representing 99% of all stock and ETFs options. As a market strategist, I have witnessed rare but significant exposure with vertical spread trades that have lost substantially more than the max risk of a strategy due to these two risks. European Cash Settled index options outright eliminates these risks.
What is assignment risk, and how can I avoid it?
With American-style options, a call or put can be exercised at any time by the buyer before expiration. Even when a spread is covered by a long option, an early exercise would require a short option holder to have the capital to buy or sell those shares. Most investors with a spread position may not have the cash or margin required to buy or sell the securities of the short leg. Even to exercise the offsetting long option would require the cash or margin to exercise and satisfy the obligation of the short option. For investors without the capital, it forces the broker to liquidate the entire position upon an early exercise.
While this risk cannot be avoided when trading American Style stock or ETF options, European-style Index Options on the Nasdaq-100 eliminate this risk entirely, they simply cannot be exercised early. Especially for new options traders, removing this element of risk is a way to flatten the learning curve and reduce the factors to consider on a trade. However, for investors trading American Style stock or ETF options, this risk can be minimized but not eliminated by closing out short option positions at least two weeks before expiration.
What is exercise risk, and how can I avoid it?
Exercise risks are rare but occur when an investor incorrectly anticipates an underlying security's value immediately after expiration. An example, is a short call or put option that expires worthless and 'out-of-the-Money" (OTM) based on expiration Friday's closing price but opens up Monday' In-the-money" (ITM). In this scenario, a short option investor may be inclined to let their short options expire worthless without buying back the call or put to remove the obligation. However, news, earnings, or other catalysts after the close causes the option buyer to anticipate a favorable move by Monday's open and exercises their option despite it being OTM on expiration Friday. This causes a short option that should have realized its full profit as of Friday's close with no exposure, to be exposed on Monday with a surprise underlying equity position. In comparison, these scenarios are rare but occur when earnings reports or material news are released after the close on Friday. For an index, these could be geopolitical events or macroeconomic news that cause an OTM option buyer to still exercise the call or put.
The best practice for avoiding exercise risk is simply closing out all short option positions, even if they are OTM before expiration. Paying a few cents to buy back a call or put that is nearly worthless will significantly outweigh the risk of exercise risk. However, with European cash-settled index options such as on the Nasdaq-100 Index, options that expire worthless can never be exercised, and gains are settled to cash based on Friday's close, eliminating all exercise risks.
Despite the benefits and advantages of trading index options, ETF options have historically provided better flexibility on sizing. Index options on the Nasaq-100 Index had large notional value, reducing the ability for smaller retail traders to utilize them. However, with the new XND product launch, a 1/100th value of the full Nasdaq-100 Index, retail traders can have the best of both worlds. XND provides the advantages of index options, with a contract sizing that is roughly a 1/3rd of QQQ.
Nasdaq-100 Index and ETF Listed Options
Trading options involve tracking a significant number of variables, including assignment and exercise risk. While both Index and ETF options provide exposure to the same index European style and cash-settled, which eliminate the assignment and exercise risks embedded in an American style option. Moreover, the tax advantage provided by Index options, can lower a tax bill on similar trades. Lastly, the new retail focused XND product, provide investors of all sizes the ability to benefit from the reduced risk of index options.
To learn more about the launch of XND, don’t miss our Introduction to Trading Index Options webinar. Watch the event replay here.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.