We use cookies to understand how you use our site and to improve your experience. This includes personalizing content and advertising. To learn more, click here. By continuing to use our site, you accept our use of cookies, revised Privacy Policy and Terms of Service.
You are being directed to ZacksTrade, a division of LBMZ Securities and licensed broker-dealer. ZacksTrade and Zacks.com are separate companies. The web link between the two companies is not a solicitation or offer to invest in a particular security or type of security. ZacksTrade does not endorse or adopt any particular investment strategy, any analyst opinion/rating/report or any approach to evaluating individual securities.
If you wish to go to ZacksTrade, click OK. If you do not, click Cancel.
In periods of high stock market volatility such as we’ve been experiencing lately, it’s understandable that many investors consider trading index options. They can be a way to buy protection against a market decline, make a limited risk, short term, directional bet – on either further market declines or a fast rebound – or to sell options in an attempt to capitalize on increased implied volatilities.
Let’s take a look at the market mechanics of the options that are available to trade.
The first successful index options product was the OEX – the Chicago Board Options Exchange (CBOE - Free Report) options on the S&P 100 index. Introduced in 1983, they quickly became the preferred instrument for traders to transfer risk in a broad based, large cap equity index. Over time, the OEX options were surpassed in popularity by the SPX – options on the S&P 500. Public awareness of the 500 index, European-style exercise and the existence of a liquid S&P 500 futures contract traded at the Chicago Mercantile Exchange (CME - Free Report) that could be used as a hedge made the SPX a better choice for most traders. SPX became the highest volume and most liquid index options in the world.
One of the features that makes SPX attractive is that it is “cash settled” – meaning that when an option expires in the money and is exercised, the long and short sides to an option exchange the difference between the index settlement price and the strike price in cash rather than shares of stock. Because of the European-style exercise, options are only exercised at expiration. The owner of a long option is free to sell it in the market any time he likes, but unlike an option on a single stock, he cannot exercise it early.
(Note: It’s not actually the two counterparties to the original trade who make the transfer. The Options Clearing Corporation act as the center counterparty, collecting debits owed and distributing them to those owed credits – and ensuring through its margin system that all market participants are sufficiently well capitalized to cover their trading activity, eliminating the possibility of default.)
In the 1990s, the popularity of Exchange Traded Funds that track the movement of broad-market indexes and the subsequent listing of options on those ETFs gave traders and investors another way to gain exposure to the movement of the indexes.
To illustrate the difference that cash settlement makes, let’s look at options on the SPX as well as options on SPY, which is the ETF that tracks the S&P 500 and trades like an equity security.
The price of the SPY is basically 1/10 of the value of the cash S&P 500 index. A value of 2650 for the S&P 500 would mean the SPY is trading around $265/share.
Because of the interest costs associated with holding an equity security as well as the fact that the SPY passes through dividends to investors, the price is not exactly 1/10, but it’s fairly close - and for the purposes of our examples, the difference is negligible.
If you were to purchase a 270 strike call on SPY that expires on January 18th 2019 for $4.50, your account would be debited $450 in cash on the day you made the purchase. If at expiration, SPY was trading $275, the option would be automatically exercised and you would purchase 100 shares of SPY for $270/share. If you chose, you could immediately sell them for $275 and keep the $500 difference.
If you were to purchase the 2,700 strike call on the SPX for $45, your account would be debited $4,500 in cash on the day of the purchase, and if the price of the index was 2,750 at expiration, you would receive a cash credit of $5,000.
You can see that in terms of total profit and loss there’s very little difference between buying 10 of the SPY calls or 1 of the SPX calls.
So why would you choose one over the other?
You might chose SPY options if you are already familiar and comfortable with trading options on individual stocks and simply want a product that works exactly that same way. Also, if you were going to trade less than ten contracts or wanted the flexibility to close less than 10 contracts worth of your position at a time, SPY allows you to do that.
You might instead choose SPX if you want to avoid the possibility of taking delivery of shares of stock as a result of your trade. If you intend to hold a cash-settled option to expiration, you don’t need to do anything else. At expiration it’s either in the money and the transfer of cash happens automatically or it’s out of the money and expires worthless.
Though early exercise of SPY options is fairly rare, it is possible, whereas you can be certain that SPX options will never be exercised prior to expiration.
SPX options also offer a larger number of expiration cycles, including options that expire mid-week and options that expire in the morning after the last day of trading rather than the afternoon of the last day. If the strategy you are employing is based on the expected movement of the index around a particular event, the SPX might allow you to choose an expiration date and time that’s more closely tailored to your time frame. (Because of the greater range of choices, it’s also important to pay close attention to the expiration you’re choosing before placing an order. There are a lot of them.)
The cash-settled options may be a little imtimidating if your not familiar with them, but they're actually easy to understand and may well suit your purposes better for some strategies.
Here’s the standard “Know Your Options” caveat: Your brokerage firm may have different capital and/or margin requirements for trading cash-settled options than for equity options. If you’re in doubt, always contact them to make sure you understand their policies before making a trade.
More Stock News: This Is Bigger than the iPhone! It could become the mother of all technological revolutions. Apple sold a mere 1 billion iPhones in 10 years but a new breakthrough is expected to generate more than 27 billion devices in just 3 years, creating a $1.7 trillion market. Zacks has just released a Special Report that spotlights this fast-emerging phenomenon and 6 tickers for taking advantage of it. If you don't buy now, you may kick yourself in 2020. Click here for the 6 trades >>
See More Zacks Research for These Tickers
Normally $25 each - click below to receive one report FREE:
Image: Bigstock
Index Options: Cash-Settled vs. Stock-Settled
In periods of high stock market volatility such as we’ve been experiencing lately, it’s understandable that many investors consider trading index options. They can be a way to buy protection against a market decline, make a limited risk, short term, directional bet – on either further market declines or a fast rebound – or to sell options in an attempt to capitalize on increased implied volatilities.
Let’s take a look at the market mechanics of the options that are available to trade.
The first successful index options product was the OEX – the Chicago Board Options Exchange (CBOE - Free Report) options on the S&P 100 index. Introduced in 1983, they quickly became the preferred instrument for traders to transfer risk in a broad based, large cap equity index. Over time, the OEX options were surpassed in popularity by the SPX – options on the S&P 500. Public awareness of the 500 index, European-style exercise and the existence of a liquid S&P 500 futures contract traded at the Chicago Mercantile Exchange (CME - Free Report) that could be used as a hedge made the SPX a better choice for most traders. SPX became the highest volume and most liquid index options in the world.
One of the features that makes SPX attractive is that it is “cash settled” – meaning that when an option expires in the money and is exercised, the long and short sides to an option exchange the difference between the index settlement price and the strike price in cash rather than shares of stock. Because of the European-style exercise, options are only exercised at expiration. The owner of a long option is free to sell it in the market any time he likes, but unlike an option on a single stock, he cannot exercise it early.
(Note: It’s not actually the two counterparties to the original trade who make the transfer. The Options Clearing Corporation act as the center counterparty, collecting debits owed and distributing them to those owed credits – and ensuring through its margin system that all market participants are sufficiently well capitalized to cover their trading activity, eliminating the possibility of default.)
In the 1990s, the popularity of Exchange Traded Funds that track the movement of broad-market indexes and the subsequent listing of options on those ETFs gave traders and investors another way to gain exposure to the movement of the indexes.
To illustrate the difference that cash settlement makes, let’s look at options on the SPX as well as options on SPY, which is the ETF that tracks the S&P 500 and trades like an equity security.
The price of the SPY is basically 1/10 of the value of the cash S&P 500 index. A value of 2650 for the S&P 500 would mean the SPY is trading around $265/share.
Because of the interest costs associated with holding an equity security as well as the fact that the SPY passes through dividends to investors, the price is not exactly 1/10, but it’s fairly close - and for the purposes of our examples, the difference is negligible.
If you were to purchase a 270 strike call on SPY that expires on January 18th 2019 for $4.50, your account would be debited $450 in cash on the day you made the purchase. If at expiration, SPY was trading $275, the option would be automatically exercised and you would purchase 100 shares of SPY for $270/share. If you chose, you could immediately sell them for $275 and keep the $500 difference.
If you were to purchase the 2,700 strike call on the SPX for $45, your account would be debited $4,500 in cash on the day of the purchase, and if the price of the index was 2,750 at expiration, you would receive a cash credit of $5,000.
You can see that in terms of total profit and loss there’s very little difference between buying 10 of the SPY calls or 1 of the SPX calls.
So why would you choose one over the other?
You might chose SPY options if you are already familiar and comfortable with trading options on individual stocks and simply want a product that works exactly that same way. Also, if you were going to trade less than ten contracts or wanted the flexibility to close less than 10 contracts worth of your position at a time, SPY allows you to do that.
You might instead choose SPX if you want to avoid the possibility of taking delivery of shares of stock as a result of your trade. If you intend to hold a cash-settled option to expiration, you don’t need to do anything else. At expiration it’s either in the money and the transfer of cash happens automatically or it’s out of the money and expires worthless.
Though early exercise of SPY options is fairly rare, it is possible, whereas you can be certain that SPX options will never be exercised prior to expiration.
SPX options also offer a larger number of expiration cycles, including options that expire mid-week and options that expire in the morning after the last day of trading rather than the afternoon of the last day. If the strategy you are employing is based on the expected movement of the index around a particular event, the SPX might allow you to choose an expiration date and time that’s more closely tailored to your time frame. (Because of the greater range of choices, it’s also important to pay close attention to the expiration you’re choosing before placing an order. There are a lot of them.)
The cash-settled options may be a little imtimidating if your not familiar with them, but they're actually easy to understand and may well suit your purposes better for some strategies.
Here’s the standard “Know Your Options” caveat: Your brokerage firm may have different capital and/or margin requirements for trading cash-settled options than for equity options. If you’re in doubt, always contact them to make sure you understand their policies before making a trade.
More Stock News: This Is Bigger than the iPhone! It could become the mother of all technological revolutions. Apple sold a mere 1 billion iPhones in 10 years but a new breakthrough is expected to generate more than 27 billion devices in just 3 years, creating a $1.7 trillion market. Zacks has just released a Special Report that spotlights this fast-emerging phenomenon and 6 tickers for taking advantage of it. If you don't buy now, you may kick yourself in 2020. Click here for the 6 trades >>