The trading world has evolved at an exponential rate since the mid-1970s. Fueled in large part by the vast expansion of technological capabilities - and combined with the ability of financial firms and exchanges to create new products to address each new opportunity - investors and traders have at their disposal a vast array of trading vehicles and trading tools. In the mid-1970s, the primary form of investment was simply to buy shares of an individual stock in hopes that it would outperform the broader market averages.

Around this time, mutual funds started to become more widely available which allowed more individuals to invest in the stock and bond markets. In 1982, stock index futures trading began. This marked the first time that traders could actually trade a specific market index itself, rather than the shares of the companies that comprised the index. From there things have progressed rapidly. First came options on stock index futures, then options on indexes, which could be traded in stock accounts. Next came index funds, which allowed investors to buy and hold a specific stock index. The latest burst of growth began with the advent of the exchange-traded fund (ETF) and has been followed by the listing of options for trading against a wide swath of these new ETFs.

SEE: The Lowdown On Index Funds

An Overview of Index Trading
A market "index" is simply a measure designed to allow investors to track the overall performance of a given combination of investment instruments. For example, the S&P 500 Index tracks the performance of 500 large-cap stocks while the Russell 2000 Index tracks the movements of 2,000 small-cap stocks. While such market indexes track the "big picture" of price trends, the fact is that for most of the 20th century the average investor had no avenue available to actually trade these indexes. With the advent of index trading, index funds and index options that threshold was finally crossed.

The Vanguard family of funds became the first fund family to offer a variety of index mutual funds, with the most prominent being the Vanguard S&P 500 Index Fund. Other families including Guggenheim Funds and ProFunds took things to an even higher level by rolling out, over time, a wide variety of long, short and leveraged index funds.

SEE: An Introduction To Sector ETFs

The Advent of Index Options
The next area of expansion was in the area of options on various indexes. The listing of options on various market indexes allowed many traders for the first time to trade a broad segment of the financial market with one transaction. The Chicago Board Options Exchange (CBOE) offer listed options on over 50 domestic, foreign, sector and volatility based indexes. A partial listing of some the more actively traded index options appears in Figure 1.

Ticker Index Tracked
DJX Dow Jones Industrial Average Index Options
NDX Nasdaq 100 Index Options
OEX S&P 100 Index Options (American style)
RUI Russell 1000 Index
RUT Russell 2000 Index
SPX S&P 500 Index Options
VIX CBOE Volatility Index® (VIX®) Options
XEO S&P 100 Index Options (European style)
Figure 1: Some major market indexes available for option trading on the CBOE.


The first thing to note about index options is that there is no trading going on in the underlying index itself. It is a calculated value and exists only on paper. The options only allow one to speculate on the price direction of the underlying index, or to hedge all or some part of a portfolio that might correlate closely to that particular index.

ETFs and ETF Options
An ETF is essentially a mutual fund that trades like an individual stock. As a result, anytime during the trading day an investor can buy or sell an ETF that represents or tracks a given segment of the markets. The vast proliferation of ETFs has been another breakthrough that has greatly expanded the ability of investors to take advantage of many unique opportunities. Investors can now take long and/or short positions - as well as in many cases, leveraged long or short positions - in the following types of securities:

  • Foreign and Domestic Stock Indexes (large-cap, small-cap, growth, value, sector, etc.)
  • Currencies (yen, euro, pound, etc.)
  • Commodities (physical commodities, financial assets, commodity indexes, etc.)
  • Bonds (treasury, corporate, munis international)

As with index options, some ETFs have attracted a great deal of option trading volume while the majority have attracted very little. Figure 2 displays some of the ETFs that enjoy the most attractive option trading volume.

ETF Ticker
SPDR Trust SPY
PowerShares QQQ Trusts QQQQ
Financial Select Sector SPDR XLF
iShares Russell 2000 Index Fund IWM
iShares FTSA/Xinhua China 25 FXI
iShares MSCI Emerging Markets Index EEM
SPDR Gold Trust GLD
Market Vectors Gold Miners GDX
SPDR S&P Retail XRT
iShares MSCI EAFE Index Fund EFA
SPDR Dow Jones Industrial Average ETF DIA
SPDR Energy Sector XLE
iShares MSCI Brazil Index Fund EWZ
US Natural Gas Fund ETF UNG
iShares Silver Trust SLV
Figure 2: ETFs with Active Option Trading Volume.


While ETFs have become immensely popular in a very short period of time and have proliferated in number, the fact remains that the majority of ETFs are not heavily traded. This is due in part to the fact that many ETFs are highly specialized or cover only a specific segment of the market. As a result, they simply have only limited appeal to the investing public.

The key point here is simply to remember to analyze the actual level of option trading going on for the index or ETF you wish to trade. The other reason to consider volume is that many ETFs track the same indexes that straight index options track, or something very similar. Therefore, you should consider which vehicle offers the best opportunity in terms of option liquidity and bid-ask spreads.

SEE: The Basics Of The Bid-Ask Spread

Difference No.1 Between Index Options and Options on ETFs
There are several important differences between index options and options on ETFs. The most significant of these revolves around the fact that trading options on ETFs can result in the need to assume or deliver shares of the underlying ETF (this may or may not be viewed as a benefit by some). This is not the case with index options.

The reason for this difference is that index options are "European" style options and settle in cash, while options on ETFs are "American" style options and are settled in shares of the underlying security. American options are also subject to "early exercise," meaning that they can be exercised at any time prior to expiration, thus triggering a trade in the underlying security. This potential for early exercise and/or having to deal with a position in the underlying ETF can have major ramifications for a trader.

Index options can be bought and sold prior to expiration, however they cannot be exercised since there is no trading in the actual underlying index. As a result, there are no concerns regarding early exercise when trading an index option.

SEE: ETFs Vs. Index Funds: Quantifying The Differences

Difference No.2 Between Index Options versus Options on ETFs
The amount of option trading volume is a key consideration when deciding which avenue to go down in executing a trade. This is particularly true when considering indexes and ETFs that track the same - or very similar - security.

For example, if a trader wanted to speculate on the direction of the S&P 500 Index using options, he or she has several choices available. SPX, SPY and IVV each track the S&P 500 Index. Both SPY and SPX trade in great volume and in turn enjoy very tight bid-ask spreads. This combination of high volume and tight spreads indicate that investors can trade these two securities freely and actively. At the other end of the spectrum, option trading on IVV is extremely thin and the bid-ask spreads are significantly higher. In choosing between trading SPX or SPY a trader must decide whether to trade American style options that exercise to the underlying shares (SPY) or European style options that exercise to cash at expiration (SPX).

The Bottom Line
The trading world has expanded by leaps and bounds in recent decades. Interestingly, the good news and the bad news in this are essentially one and the same. On one hand we can state that investors have never had more opportunities available to them. At the same time the average investor can easily be confused and overwhelmed by all of the possibilities that swirl around him or her.

Trading options based on market indexes can be quite profitable. Deciding which vehicle to use - be it index options or options on ETFs - is something that you should give some serious consideration to before "taking the plunge."

Related Articles
  1. Options & Futures

    Exploring European Options

    The ability to exercise only on the expiration date is what sets these options apart.
  2. Mutual Funds & ETFs

    Which Mutual Fund Market Cap Suits You?

    Different funds invest in companies with different market caps. Find out which is right for you.
  3. Options & Futures

    Using Options Instead Of Equity

    Learn how to multiply returns and diversify risk by buying options instead of stock.
  4. Mutual Funds & ETFs

    The VIX: Using The "Uncertainty Index" For Profit And Hedging

    Learn the best ways to profit and hedge using the Chicago Board Options Exchange Market Volatility Index.
  5. Options & Futures

    Are You Ready To Trade Futures?

    If you want to trade futures in the hopes that you'll become rich, you'll have to answer some questions first.
  6. Investing Basics

    Explaining Options Contracts

    Options contracts grant the owner the right to buy or sell shares of a security in the future at a given price.
  7. Home & Auto

    When Are Rent-to-Own Homes a Good Idea?

    Lease now and pay later can work – for a select few.
  8. Mutual Funds & ETFs

    ETF Analysis: ProShares UltraPro Nasdaq Biotech

    Obtain information about an ETF offerings that provides leveraged exposure to the biotechnology industry, the ProShares UltraPro Nasdaq Biotech Fund.
  9. Mutual Funds & ETFs

    ETF Analysis: iShares MSCI Europe Financials

    Learn about the iShares MSCI Europe Financials fund, which invests in numerous European financial industries, such as banks, insurance and real estate.
  10. Mutual Funds & ETFs

    ETF Analysis: SPDR S&P Insurance

    Learn about the SPDR S&P Insurance exchange-traded fund, which follows the S&P Insurance Select Industry Index by investing in equities of U.S. insurers.
RELATED TERMS
  1. Derivative

    A security with a price that is dependent upon or derived from ...
  2. Exchange-Traded Fund (ETF)

    A security that tracks an index, a commodity or a basket of assets ...
  3. Security

    A financial instrument that represents an ownership position ...
  4. Series 6

    A securities license entitling the holder to register as a limited ...
  5. Internal Rate Of Return - IRR

    A metric used in capital budgeting measuring the profitability ...
  6. Board Of Directors - B Of D

    A group of individuals that are elected as, or elected to act ...
RELATED FAQS
  1. How do futures contracts roll over?

    Traders roll over futures contracts to switch from the front month contract that is close to expiration to another contract ... Read Full Answer >>
  2. What does a high turnover ratio signify for an investment fund?

    If an investment fund has a high turnover ratio, it indicates it replaces most or all of its holdings over a one-year period. ... Read Full Answer >>
  3. Does index trading increase market vulnerability?

    The rise of index trading may increase the overall vulnerability of the stock market due to increased correlations between ... Read Full Answer >>
  4. How does a forward contract differ from a call option?

    Forward contracts and call options are different financial instruments that allow two parties to purchase or sell assets ... Read Full Answer >>
  5. What is the difference between passive and active asset management?

    Asset management utilizes two main investment strategies that can be used to generate returns: active asset management and ... Read Full Answer >>
  6. Why do companies enter into futures contracts?

    Different types of companies may enter into futures contracts for different purposes. The most common reason is to hedge ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!