Many beginning options traders are initially confused at the differences between cash indices options, such as SPX, and options traded on ETFs and stocks, such as AAPL or SPY.
After all, indices like SPX cannot be traded on the stock market. It’s only an index! Let’s clarify those differences. First, we must recognize why options exist on a cash index like SPX when those same options can be traded on the S&P 500 ETF, SPY.
An index like NDX or SPX are simply math calculations. Those calculations take each component’s weight in the index and automatically calculate the index price based on the underlying components’ price changes.
While these shares cannot be traded, you can trade options on them. How the options trade is slightly different from the traditional stock options people are generally accustomed to.
Alternatively, an ETF like SPY is a company that holds shares reflecting index components in a trust. Therefore, when SPY is traded, a portion of the trust is also being traded.
Trading options or shares of AAPL or IBM is not fundamentally different than trading shares or options on SPY.
Before diving into the individual differences between the index and stock options, let’s settle on the definition of an option.
What is an Option?
An option is a contract between a seller of an asset and a buyer. Options contracts can be used in a variety of situations and industries, such as real estate.
An option contract grants the buyer the right, not the obligation, to purchase an asset at a specified price on or before a specified date.
For example, you and a friend might agree to an option contract on your house. Your friend pays you $1,000 for the right to purchase your home at the current market price for the next six months.
You may pocket the $1,000, also known as the premium in the options market, but you can’t sell the house until the original agreement expires.
Options are that straightforward. Perhaps you are in a situation when your friend does not have the capital to buy your house that day, but your friend wants to purchase using the current price, so he or she would pay you an option premium for the right to acquire it in the next six months.
In the stock market, options can be bought or sold on any stock/ETF/future, regardless if you have ownership of it.
Now, let’s discuss the differences between index options and stock options.
List of Index Options
Below is a list of the most popular index options available on exchanges in the US:
- $NDX – NASDAQ 100 Index
- $DJX – Dow Jones Industrial Average 1/100 Index
- $SPX – S&P 500 Index
- $VIX – S&P 500 Volatility Index
- $RUT – Russell 2000 Index
- $OEX – S&P 100 index
- $XEO – S&P 100 (European) Index
Remember, many brokers and charting platforms require to prefix the ticker with the dollar sign ($) since these are ‘cash’ indices. Others would only need the ticker.
Other cash-settled index options may trade on US exchanges, but they are mostly traded sparsely. The CBOE has a list of other offered index options.
Index Options Require More Capital
An index option, such as the SPX, necessitates more capital per contract than SPY, its ETF counterpart, due to the higher price of the SPX, approximately ten times more expensive.
For example, the current SPY price can be $347, while the current SPX price can be $3,471.
Contracts are denominated for 100-share lots for both tickers. It can be expected for SPX options to be priced more than ten times the amount of a SPY option.
Index Options Are Cash Settled
European-style options, or Index options, are similar to the American-style options when it comes to individual stocks like Apple or Amazon.
They do have a few key differences. One of those is the settlement.
Index Options Are Taxed Like Futures
Index options most often receive a higher volume than ETF counterparts because of the difference in their tax treatments. The IRS code has designated index options as “1256 contracts,” allowing them special tax treatment. Take a look at the unique tax treatments below:
- 60/40 Tax Treatment
- Treat 40% of your P&L as short-term capital gains
- Treat 60% of your P&L as long-term capital gains
- This applies regardless of holding period, making futures and index options more tax-advantageous than their ETF counterparts.
- Not subject to wash-sales (this impacts day traders)
- P&L is set to market at the end of the year, no matter if you closed your position.
Here’s an example that illustrates the benefit of the 60/40 rule for index options. Say you trade an Amazon option, making $100 in gross profits with a one week holding period.
Next, say you trade an index option and obtain $100 in gross profits with another one-week holding period.
The entire $100 stock option is subject to short-term capital gains tax. The tax rates can fluctuate greatly depending on your annual income.
- Total taxes owed: $37
- Directed to highest short-term capital gains tax: 37%
- $100 profit
- $100 profit
- conditional on highest short-term capital gains tax for 40% of profits: 37%
- Long-term taxes owed: (100 * .6) * .2 = $12
- conditional on highest long-term capital gains tax for 60% of profits: 20%
- Total taxes owed: $12.00 + $14.80 = $26.80
- Short-term taxes owed: (100 * .4) * .37 = 14.80
If you add some zeroes to the end of those numbers, you can see how significant the savings are at a scale.
Index Options Have Different Settlement Rules
Stock options and index options have very different rules as far as settlement goes. If you do not know all of these differences, it will land you in a world of trouble
often when talking about the nuances of settlement can be tedious, but you only need to learn it once, and when you do, it will give you a boost and save you from a big headache.
The first difference is on what day expiration falls. if you trade stock options often, you might know that Friday is usually expiration day, but with index options, they are often settled on Thursdays
The time of expiration is different as well in a sense, being that index options settle based on the previous trade made on Friday morning, and then stock options expire on Fridays.
Pros and Cons of Index Options
- The small number of indices may be a benefit because you have fewer things to focus on.
- More liquid markets
- Preferable tax treatment
- Cash settlement makes everything much more straightforward.
- Less potential to find inefficiently priced options
- Generally require more capital to trade.
- Not as many choices due to the thousands of optionable stocks, in comparison to a handful of optionable indices.
Index options offer traders and investors the chance to easily contemplate or hedge their positions in a liquid market with advantageous tax treatment.
They are not for everyone, as their vast buying power conditions lockout smaller traders.
- Index options have different expiration dates.
- Index options receive preferential tax treatment.
- Index options are generally more liquid.
- Index options are cash-settled instead of physically settled.