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Index Options vs ETF Options

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Trading options on the main US indices is growing in popularity every year. But what are the best ways to do this? There are two very similar assets to choose from – SPY which is an Exchange Trade Fund and SPX which is an Index. Both are very popular with great liquidity, but what’s the difference?

Let’s take a look at some of the factors when considering “Should I trade Index options or ETF options?”

Contents

Commissions

This is the big one for me.  If you have a broker (such as Interactive Brokers) who charge per contract, then it makes much more sense to trade the index options.

SPY is basically 1/10 of the value of SPX, and as such you would need to trade 10 contracts of SPY to have the same exposure as trading 1 contract of SPX.

As I use IB, the index options have a huge advantage for me.

Liquidity and Bid/Ask Spreads

Liquidity is a huge consideration when trading Iron Condors. Slippage can really eat into your profits and it takes some practice and experience in order to get good fills.

Also, opening a trade is one thing. When markets tank, the bid – ask spread widens significantly and you can get killed trying to get out of a position quickly.

Traders who are worried about liquidity, or are just starting out, should stick to the ETF’s as there will be less slippage.

When comparing liquidity on the major indexes, there is not much difference between index options and ETF options as both are very, very liquid.

At the time of writing this, an SPY at-the-money call has open interest of 160,000 and an SPX at-the-money call has open interest of 40,000.

As a side note, liquidity should also be a consideration when determining which instrument to trade.

For example, the CBOE has a monopoly on SPX options, whereas RUT is traded on multiple exchanges.

Multiple exchanges means more competition among the market markers, which means better liquidity for us. From personal experience, I have always found fills much easier on RUT.

Tax Considerations

Indexes have preferential tax treatment and as such may be more suitable for larger traders. Income from index options is treated as 60% long term and 40% short term, regardless of the trade duration.

Income from ETF options is treated the same as stock. As Iron Condor are short term trades of between 15 and 60 days, index options will be more advantageous from a tax perspective.

Capital Level

The SPY ETF is approximately 1/10 the value of the SPX Index.

Those with a smaller capital balance may be better off trading SPY, as trading SPX may mean their capital at risk is too high.

Dividends

While not a huge consideration, ETF’s pay dividends while index’s do not. When an ETF goes ex-dividend, the price usually drops by the amount of the dividend.

This is something that you may need to take into consideration when selecting your strikes. ETF traders would also need to keep an eye on this close to expiration due to early assignment risk as discussed shortly.

Settlement

Trading Index options occasional provides a risk due to the settlement process.  The way it works is this.

The monthly options cease trading on Thursday at 4pm, BUT the final settlement price is calculated based on the prices that each stock in the index opens at on Friday.

So, if there is a big gap up or down on the Friday morning the final settlement value could be significantly different to what you would expect based on Thursday’s close.

This can cause a problem if you are holding an Iron Condor that is close to the money, a big gap up or down could mean that your sold option finishes in-the-money on settlement even though you were nice and safe when the market closed on the Thursday.

If you visit the link below and compare the settlement values to the closing price on the Thursday and you will see what I mean.

http://www.cboe.com/data/Settlement.aspx

The settlement price is usually released by about 11am on the Friday.  Index options are cash settled which means that when a sold option contract on the index settles in-the-money, cash will be withdrawn from your account.

The amount will be the difference between the strike price and the settlement price.

How do you deal with this risk?

For me this is usually not an issue because the options I trade are a long way from the market.

However, sometimes the market moves up or down and is close to the sold strikes at expiration.

The only way to 100% eliminate this risk is to close out the options on the Thursday before the close.

 I would usually do this if the index was within 1-2% of my strike prices just to be on the safe side.

Early Assignment

Early Assignment is only an issue for American style options.

Stocks and ETF’s are American style, while indexes are European style.

  If you are trading Iron Condors and credit spreads on the indexes (RUT, SPX, NDX and MNX), you don’t even need to worry about it.

For those you trade the ETF’s (IWM, SPY and QQQ) there is a risk of early assignment but the risk is incredibly low and almost not worth worrying about.

The main reason to exercise an option early is to receive the dividend, and the option would have to be deep in-the-money to do that.

The other reason might be if a large institution had a very large position, it might be cheaper to exercise early than to sell the position in the market and pay the bid / ask spread.

For puts options, the main reason to exercise early would be in the case of a company going bankrupt.

In that case, you are holding an option to sell the stock for the exercise price, and there is absolutely nothing gained by waiting until expiration to exercise it.

Realistically, neither of these scenarios are likely, particularly if you are trading the ETF’s as SPY cannot go bankrupt (unless all the stocks in the ETF go bankrupt and geez I hope that never happens…)

If you are trading the American style options, you would be adjusting your positions before the options go in-the-money so again, there is very little risk of early assignment.

Trade safe!
Gav.

vol trading made easy

3 Comments
  1. Michael says:

    Hello, i’m having trouble finding a definitive answer by the liquidity. At the money or very near in the money options for SPY, two questions, how quickly can 500 simple single leg contracts get filled? Would it be relatively instantaneous like in like trading securities? 3 seconds? 30 seconds? Thank you.

    1. Gavin says:

      Hi Michael,

      For SPY options, you can get filled basically straight away, the spread is very tight, usually only 1-2 cents. SPX will take longer as the spreads are wider. Depends on how picky you are about getting a good fill price. Market orders will always be filled straight away, but probably not at a price you would be happy with.

  2. Edgar says:

    Hi Gavin
    So in wich level of IV rank or percentile do you prefer to work for set up IRON CONDOR with index or ETF?

    THX

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Options Trading 101 - The Ultimate Beginners Guide To Options

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