Wednesday, December 23, 2009

Mail Time- Index vs. ETF Options

Hi Tyler - do you prefer using index options versus the options on the ETF for the index? If so, why? What are the similarities and differences that one should be aware of when using index options? Thanks!
Rene-


Thanks for the question Rene. The two biggest things you want be aware of when trading index options are the style of option and the details of settlement. Within the CBOE website you can view the product specifications of the various index options. I suggest spending some time on the site getting familiar with any index options you plan on trading.

Style of Option: Since the ETF's have underlying shares you can purchase, their options are typically American Style which means they be exercised any time prior to expiration. The majority of index options are European Style which means they can't be exercised early. This comes into play if you're shorting options that move in-the-money. With European Style options you have no risk of early assignment; with American Style options you do have risk of early assignment.

Settlement: American style options (including those on ETF's) are settled in stock, the European style options are typically settled in cash. So if I shorted a 500 call on a European style index and settlement price came in at 510, my short call would be $10 in-the-money. Consequently, the option seller (me) would have to pay out $1000 and the option owner would receive $1000.

The last trading day for most European style index options- including SPX, NDX, RUT- is on Thursday, one day prior to the 3rd Friday of the month. Settlement price is a theoretical price calculated based off of the market open on Friday. Settlement prices are posted on this CBOE website sometime following the open on expiration Friday.

As to whether one should trade index options or ETF's, such as the SPX vs. SPY, there are a couple things to consider.

Bid-Ask Spread: Sometimes index options have very wide bid-ask spreads ($2 or more) making it difficult to get a good fill. When playing the S&P, I've preferred using the SPY vs. SPX options. When trading the Russell 2000 however, I typically stick to RUT options as they usually have pretty tight bid-ask spreads- particularly the out-of-the-money options I deal with.

Commission: When trading ETF options, you usually have to purchase more contracts. For example a $10 vertical spread on the SPX would require $1000 of margin and consist of 2 contracts. The equivalent of the SPY would be 10 $1 vertical spreads and require 20 contracts. If you've got a high commission broker, it makes it a bit more difficult to make it worth your while with narrow spreads on ETF options. When I play with the SPY I typically do a $4 or $5 spread to cut down on the amount of commission.

There may be other factors, but these are probably the most obvious ones that I've seen. If I've missed any notable differences, pipe in within the comments section-

For a related post, check out:

11 comments:

Anonymous said...

Hi Tyler,

I've found a VIX ETF (VXX) that's supposed to track the VIX index, but it does this job very bad, as lots of guys are saying on blogs.

Maybe it's not easy to create a good tracking ETF, but why ?


Cheers,
Siull

semuren said...

index options are 1256 contracts and get better tax treatment than ETF options

Tyler Craig said...

Good point Semuren. Thanks-

Tyler Craig said...

Siull,

The nuances of why VXX has had tracking difficulties have been covered in depth in a few different blogs I frequent. I'll post some links and give my thoughts in my next post- probably tomorrow

Mark Wolfinger said...

Holding thru settlement is a bad idea.

Too many index traders have no idea how the settlement price is calculated - and complain bitterly about that price.

Tyler Craig said...

I'm with ya on that Mark. Unfortunately most people don't take the time to learn the product specifications until AFTER they've been shafted and realize settlement can be quirky for the indices. I enjoyed the explanation in your book- well said.

Rene said...

Fantastic, thanks Tyler.
Rene

Tyler Craig said...

your welcome Rene-

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