We are now gearing up to add RUT index options to the book. Can anyone think of any reason why I can't treat the deliverable of these options as 1000 x IWM (1/10th RUT ETF) for delta hedging purposes? Obviously our clearing processes must handle these as cash-settled (market on open), European options but we know how to do that already. It seems like IWM loses about 1% p.a. in relative value vs RUT, which is also something we can factor in. Is there anything else that I'm missing?Does anyone have a view on the additional risk that being a cash-settled option brings? I've heard anecdotal stories about an index being pushed around for the open in order to move big positions into/out the money at settlement time. For physically settled options, this isn't an issue since one can simply finance the position in the underlier until it comes back into line. However, manipulation at settlement for a cash-settled options has a real economic impact. How big an issue is this for index-options? Would anyone like to share a story of being burned?

the "anectodal stories" i've read about relate to the difference between the last trading of RUT and its settlement. for example, here.

Turns out there's another nit that took me a while to puzzle out. RUT options track the RUT index (RTY Index GO on Bloomberg), IWM track the related RU20INTR index (RU20INTR Index GO on Bloomberg). The difference is that RUT is "Price" weighted, while RU20INTR is "Total Return" weighted. In other words, RU20INTR "reinvests" any distributions while RUT simply ignores them. In practice, this means that my assumption of 1000 x IWM as the hedge for a unit of RUT risk was incorrect. Instead, I need to use alpha = RUT price * 100 / IWM price as the correct hedge ratio. This value will jump up on the ex-date as the market takes the quarterly dividend out of IWM, but not RUT. This mechanism is what allows IWM to stay roughly 1/10th of RUT over the long run, despite paying quarterly dividends. Conceptually, this approach will force us to "reinvest" any IWM dividend on the ex-date in order to maintain the correct hedge ratio. Comments, anyone?