ETF Options vs. Index Options: An Overview
In 1982, stock index futures trading began. This marked the first time traders could actually trade a specific market index itself, rather than the shares of the companies that comprised the index. 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.
- An exchange-traded fund (ETF) is essentially a mutual fund that trades like a stock.
- ETF options are traded the same as stock options, which are "American style" and settle for shares of the underlying ETF.
- Index options are settled “European style,” which means they are settled in cash.
- Index options cannot be exercised early while ETF options can.
ETF Options Vs Index Options
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 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 options trading volume while the majority have attracted very little. Figure 2 displays some of the ETFs that enjoy the most attractive option trading volume on the CBOE.
|iShares Russell 2000 Index Fund||IWM|
|PowerShares QQQ Trusts||QQQQ|
|iShares MSCI Emerging Markets Index||EEM|
|SPDR Gold Trust||GLD|
|Financial Select SPDR||XLF|
|Energy Select SPDR||XLE|
|SPDR Dow Jones Industrial Average ETF||DIA|
|Market Vector Semiconductors ETF||SMH|
|Market Vector Oil Services ETF||OIH|
A 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.
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.
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.
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.
The amount of options 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 similar, security.
For example, if a trader wanted to speculate on the direction of the S&P 500 Index using options, they have 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.