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Trading options based on market indexes can be a profitable endeavor. But investors have much to consider when they’re deciding between ETF and index options.

For starters, a market index is a measure of the performance of a given combination of investments. For example, the S&P 500 index tracks the performance of 500 large-cap stocks.

The advent of index trading, index funds and index options enabled investors to trade market indexes. Next came the trading of index options, which allowed investors to speculate on the price direction of the underlying index, and to hedge all or some part of a portfolio that might correlate closely to that particular index.

An exchange-traded fund is essentially a mutual fund that trades like a stock. ETFs track a given market segment. They offer investors the opportunity to take long or short positions in foreign or domestic indexes, currencies, commodities and bonds.

The most significant difference between index and ETF options is that trading options on ETFs can result in the need to assume ownership or deliver shares of the underlying ETF. This is not so with index options because they’re European style, meaning they’re settled in cash.

ETFs are American style – they’re settled with the underlying security’s shares. American options can also be exercised early, which will trigger a trade in the underlying asset. Index options have no trading in the underlying index, and cannot be exercised early.

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