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ETF Option Trading Versus Index Option Trading
07/30/2014 8:00 am EST
Alan Ellman of TheBlueCollarInvestor.com maps out the differences between ETF option trading and index option trading.
Most options traders—including covered call writers—are familiar with exchange traded funds (ETFs) and many trade options on these securities. Many have also heard of—but are not as familiar with—index options. The purpose of this article is to detail the differences between ETF option trading and index option trading.
Exchange traded fund (ETF):
This is a security that tracks an index, a commodity, or a basket of assets, but trades like a stock on an exchange. It can be bought and sold throughout the trading day and has price fluctuations as do individual stocks. One major advantage is that these securities provide diversification. Many ETFs have options associated with them.
This is an imaginary portfolio of securities representing a particular market or segment of a market. The S&P 500 is an example of a commonly used index. Another example is the Russell 2000 index, which tracks 2000 small-cap stocks. Here are a few such indexes that have actively traded options:
Note that there is no trading taking place in the underlying index but rather has a calculated value that exists on paper only. Options allow the trader to speculate on price direction.
These are professionally managed, diversified portfolios that do not trade like stocks and do not have options associated with them. I include this in the definitions section so that there is clarity about ETFs and indexes being different from the much more well-known mutual funds.
Differences between ETF and Index Options
The holder of an ETF option has the right, but not the obligation, to purchase ETF shares, whereas the holder of an index option does not. Instead, the holder of an index option has the right to demand the equivalent cash value from the option seller upon exercise of the option. All index options are cash-settled. Here is the formula:
Settlement amount = (Difference between index value and the strike price) x $100
Early exercise of American Style options is rare but possible.
Style of options traded
When we sell options on stocks or ETFs, we are selling American Style options. This means that they are settled in shares of the underlying security and can be exercised at any time up to expiration (usually 4:00PM EST on the third Friday of the month).
When options on indexes are sold, European Style Options are generally used (S&P 100 Index Options (OEX) are an exception). These are cash-settled, can be bought and sold prior to expiration but can only be exercised on expiration. There are no concerns for early exercise with index options.
ETF options are settled based on the closing price as of 4:00PM EST on expiration Friday (or the Thursday before if Friday is an exchange-recognized holiday). Index options can have an AM Settlement (based on opening prices of the day of exercise) or PM Settlement (based on closing prices on the day of exercise). For European style index option contracts, the last trading day will be the business day (generally a Thursday) preceding the day on which the exercise settlement value is calculated (generally the third Friday of the month unless that day is a holiday).
By Alan Ellman of TheBlueCollarInvestor.com
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