“Closing Rotation”, “Deja Vu All Over Again”

Today is a shortened session, with stocks, equity and ETF options closing at Noon Chicago time, while Broad Based Indexes and Futures trade until 12:15pm.

There was a CBOE Information Circular released last week mentioning a “Closing Rotation” in SPX Options after the close today, this being the last trading day of the month.  We used to do a Closing Rotation at the close of trading every expiration in the front month and in all series on the last day of the year.

What is a Closing Rotation?  There are times when the last sale of an option might not reflect a “fair” value of the option price.  For example, let’s take XYZ closing at $100 per share.  The 90 Strike Call (expiring in 2 weeks) last traded at $9 yesterday, did not trade today, and was $9.90 bid, offered at $10.20 at the close of trading today.  Most brokerage firms use the last sale to price the option, or (in this case) would use the bid price of $9.90 because it was higher than the last sale.  The problem with that, is the 90 strike call is intrinsically worth $10.  Is $9.90 a “fair price”, especially at the end of a month, quarter or a year?

In a closing rotation, bids and offers are made by traders to line up the “fair value” of options.  This is not a trading session.  It is conducted by traders or the DPM (Designated Primary Market-maker) in that security.  So the DPM in the Closing Rotation might make the 90 strike call $10 Bid (making the option worth parity to the stock) or perhaps $10.10 bid.  Why $10.10?  Their pricing model might tell them the option with two weeks until expiration should have ~$0.10 of time premium, in addition to the $10 of intrinsic value.

As a floor trader, I would have sizable swings in my account at the end of every trading day because of the way options closed.  If I’m long a $5 point vertical spread, should it go out at $5.50?  In the example of the 90 strike calls and the stock at $100, if I’m short the 90 strike call is $9.90 a fair price?  The only time it is important to get the price right is the end of a month, end of a quarter of the end of the year.

The reason for the CBOE Information Circular was to reminding the firms and traders of the early close, and this being an end of month, closing rotation was moved to an earlier time in some index products.

So as Yogi Berra, one of the great philosophers of our time might have said, “Trading is ninety percent mental and the other half is physical”.

Have a nice weekend.