Which Is Best: ETF Options or Index Options?

05/11/2015 8:00 am EST

Focus: OPTIONS

The vehicles open to traders are now more numerous than ever, but there are important differences to consider between these two strategies, says Jay Kaeppel of Investopedia.com.

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.

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.

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 below:

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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)

Up Next: ETFs that enjoy the most attractive option trading volume...

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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.

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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.

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" options and settle in cash, while options on ETFs are "American" 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.

Difference No. 2 Between Index Options and 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."

Jay Kaeppel is a contributor to Investopedia.com.

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