Trading an Index Option vs. a Stock Option

10/23/2013 8:00 am EST

Focus: OPTIONS

Options experts Seth Freudberg and Michael Schwartz of SMB Capital discuss the pros and cons of choosing underlying vehicles for your next trade.

How do we choose the perfect security for trading options?

The evolution of options trading strategies will continue to expand but the one thing that will never change is the relationship between volatility and risk when assessing your next options trade. One of the considerations when trading options is what underlying vehicle you should trade. Should you trade options derived from an index like the S&P 500, Dow, Russell 2000, or OEX? What about using ETFs or high-priced equities such as Apple (AAPL), IBM (IBM), or Google (GOOG)?

As usual, the answer is not always so simple. There are pros and cons to each, so as an options trader it is important that you understand some of those differences before making your decision. Probably the single biggest difference is the diversification that you get with an index of 100, 500, or 2000 stocks compared to the risk associated with trading a single stock. What risk are we talking about? We're talking about a number of risks including:

1) Event/News risk

2) Earnings release risk

3) Competitive announcements

Any of the above could move the company stock dramatically and unexpectedly. When you own an index, you're still exposed to this risk, but at a much, much lower level. At the index or ETF level your risk is usually limited to market wide event risk, and just to name a few:

1) Geopolitical issues and threats

2) Fed announcements

3) Monthly employment reports, other governmentally and privately released economic reports.

However, your individual stock will most likely move with the markets during these events so they are still exposed to these same events. Therefore, the volatility associated with individual company risk is muted by the presence of other stocks in an index. While there are ETFs that mimic the big indices, there are also a lot of ETFs that focus on specific industries and niches. This would allow a trader to get exposure to oil for example but again, stay away from company-specific risk while exposing the trader to more risk than normal to industry-wide risk.

Another consideration worth looking into is the tax advantages associated with trading certain index options like the RUT, NDX, and SPX under IRS section 1256. These options could have tax advantages over other options, as they are taxed at a rate of 60/40 meaning 60% of gains or losses are considered long term holdings and 40% are taxed as short-term holdings regardless of how long you hold the option. Of course, it is important to consult with tax counsel or your accountant prior to making any options trading decisions based upon tax considerations as they are complex and subject to change.

While we have not covered all of the pros and cons of each, it is important to understand the differences in trading options with indexes, ETFs, and stocks before deciding what to trade.

By Seth Freudberg and Michael Schwartz of SMB Capital

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