Index Option Trading

I've mentioned index option trading in a number of my other pages, especially the trade of the week pages. What does this mean? 

You may have heard of index options and been intimidated by the idea. I want to take a page here and cover what an index is and how option on the index compare with regular options.

What is an index?

An index is nothing more than a collection of actual stocks that usually are grouped around some kind of industry sector or commodity. They are often used to gauge the performance of the broad market or the sector or commodity they represent.

Some examples include the $SPX, which is a representation of the valuation of the stocks in the S&P 500. This would be  a broad market index. The $SOX, the semiconductor index is an example of a sector index while the $OIX, the oil index is an example of a commodity related index.

The way an index is valued varies. Some indices are what's known as price weighted where the value of the index is essentially the sum of the total value of an equal number of stocks that make up that index. Another approach to valuation is known as capitalization weighing. In this approach, the total capitalization of each of the stocks in the index added together and divided by some divisor amount that reduces that total to some reasonable number.

It is important to understand the difference because this can affect the movement of the index for various stocks, particularly when they are higher priced stocks.

Index options 

Many (but not all) indices trade options. Generally speaking index option trading isn't much different than trading options on stocks. The pricing of the option is derived from the price and volatility of the underlying index. In most cases on contract still represents 100 shares of the underlying index.

There are a few key differences with index options. For the most part, the options we trade on stocks are American style options. Another style of options that is often found in index option trading is European style options.

European style vs American style options

Here's the bottom line with European style options. The buyer of the contract may not exercise early. What this means for a seller of options is that they don't have to worry about early assignment, a potential problem if a short position gets in the money.

Most (but not all) index options are European style. Examples include options on the RUT (Russell 2000), SPX (S&P 500), NDX (Nasdaq 100), DJX (Dow Jones 30). There are many others as well. A more complete list can be found here.

Option Expiration and Settlement

Unlike most options, which cease trading on the third Friday and expire and settle on Saturday at noon, index options are quite a bit different. Failure to understand the difference between the two can be dangerous to your trading account.

Most index options cease trading on the close of business the third Thursday before the third Friday. Settlement value is calculated based on the Friday morning opening price of each of the components of the index. It is NOT based on the opening tick of the index on that Friday morning, although it may be roughly the same price. The settlement value for each of the indices won't typically be reported until several hours later.

Why does this type of behavior pose potential problems? Let me tell you what happened to one of my trades on the NDX. I had sold a short put spread that was doing very nicely although I hadn't reached my target closing price. Thursday night, the market closed and the NDX was still $20 above my short strike. Friday morning there was some news that caused a sharp sell-off and on the market open, NDX gapped down... That's right, about $25 and now I'm in the money by $5. To make things worse, by mid morning, the market had recovered much of the gap down and the position would have expired out of the money had it settled on Saturday as most options do.

I learned 2 important lessons from this.  1) Know how the options you are trade really behave and 2) Never hold an option until expiration.

Cash Settlement

Index options are cash settled. That means if an assignment were to take place, I wouldn't be forced to buy or sell the index (depending on whether it's a put or call assignment). I would have to settle in cash. Let me give an example.

Let's say I've sold a naked $550 put on the RUT (not a good idea by the way) with the RUT trading at $580. Let's say that on Thursday's close, RUT is trading at $560 and I've decided to hold through expiration (another bad idea). Friday morning, bad news comes out before the market opens and RUT gaps down $15 has a settlement value of $545. 

I won't be assigned shares of the RUT because there is no actual stock. Instead, I will be required to pay the difference between the price I was put the RUT for ($550) and the settlement price ($450). That means I must pay the holder of the option $5 (or $500) for every contract in that position.

Advantages of index options

With all the issues I listed above, one might wonder why trade index options at all? There are actually some advantages of index option trading.

One advantage with index option trading is that fact that they are European style exercise. That means if ther was a case where the position went against me and I was in the money, I am not in danger of being assigned unless I hold it until expiration.

One of the key advantages of trading broad-based index options is the tax treatment that comes with them. This is not intended to be an authoritative tax discussion, however most broad-based index options fall under the category of Section 1256 contracts. While most other options trading fall under the category of short term capital gains (15%-35%).

Tax treatment for Section 1256 contracts is 60% long term and 40% short term. This will lower the effective tax rate to about 23%. For index option trading in larger volumes, this can make quite a difference.

ETFs as a proxy for the index

Wouldn't it be nice to have the best of both worlds? That is, the ability to trade against the broader market or specific sector and yet not have the risks associated with index option trading of the indices themselves?

There is a way with ETFs (Exchange Traded Funds). I'm not going to go into the details of what an ETF is except to say that it is essentially a stock that is backed by the stocks or commodities it represents.  That's not a 100% accurate description but good enough for the purposes of this discussion. As with anything you trade, understanding the product well before trading is a good idea.

I trade options on a lot of ETF products for several key reasons.

  1. They represent a broad sector or commodity that I want to trade
  2. They behave like a stock in almost every way
  3. They are usually highly liquid themselves and so the options are often very liquid

See more on why I trade ETF options.

Just for reference, there is a short list of ETFs, the index they track and some basic characteristics about them.

ETF Index Characteristics
DIA DJX Roughly 1/100 of the actual index
Dividends paid
SPY SPX  Roughly 1/10 of the actual index.
Dividends paid
IWM RUT Roughly 1/10 of the actual index
Dividends paid
QQQ NDX Roughly tracks the Nasdaq 100 but at different ratios
Dividends paid
GLD Gold Actually backed by gold. One share represents roughly 1/10 oz of gold
USO Oil This is backed by oil futures contracts, which can be a little tricky as the price will often adjust without apparent reason

There are many other ETFs that I like to trade that don't track the broad market indices but rather are sector or regional ETFs. Examples include XLF (Financials), XLE (Energy), EEM (Emerging Markets), and EWZ (Brazilian stocks),

The nice thing about ETFs is that there are groups of them that represent the short side of a trade. This isn't as beneficial for options traders, but it's nice to know they are there anyway.

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