Know Your Options -- ETFs vs Indexes
Knowing the distinct differences between index options and options on exchange-traded funds based on broad-based market indexes may help traders with their bottom line.
Certain exchange-traded funds (ETFs) and index options may give a trader exposure to the performance of a broad-based market index. The performance of both types of options may be influenced greatly by price changes in the underlying market.
ETF options are structured like equity options. If an ETF option is exercised, the result would be a transaction of 100 shares of the underlying ETF. For example, if you owned an in-the-money call option on the SPY at expiration, the call would be exercised. Upon exercising this option, you would own 100 shares of SPY.
This works differently for index options. Index options are settled through a cash transfer from the seller to the buyer. This cash settlement feature of index options benefits traders with no intention of taking a position with exposure to the underlying market upon expiration.
INDEX OPTIONS The vast majority of index options are European-style option contracts. The lone exception in Figure 1 is the OEX index. European-style options are allowed to be exercised only upon expiration.
All equity options, including those on ETFs, are American-style option contracts. American-style option contracts may be exercised on any business day up to and including expiration.
Whenever a short position is held in an American-style option contract, there is the possibility of being assigned on that short position.
This risk is not present with European-style options that may only be exercised at expiration.
DIFFERENCE - TAX PURPOSES
A distinct difference between ETF and index options is the potential treatment of short-term profits or losses for tax purposes. According to Taxes and Investing: A Guide for the Individual Investor, broad-based index options are defined as Section 1256 contracts, which results in two distinct characteristics.
Section 1256 contracts are treated as sold ("marked to market") on the last day of the year. Gain or loss resulting from such marking to market is treated as 60% long-term capital gain or loss and 40% short-term capital gain or loss. This commonly is referred to as 60/40 tax treatment. With respect to options on ETFs, the taxation of profits on positions held under a year would result in a short-term taxable event.
DIFFERENCE - CONTRACT SIZE
There is one final difference between index and ETF options that varies depending on the underlying index. The notional size of the contracts may vary between a similar ETF and index option series.
The easy example of this difference is the SPY and SPX option series. Both options have a 100 multiplier, but the SPY is quoted at approximately one-tenth the size of the quote of the S&P 500 index.
For instance, if the S&P 500 is at 1300.00, the SPY ETF would be close to 130.00. If you had a bullish outlook on the S&P 500, comparable trades may be buying either an SPY 130 call or SPX 1300 call.
The difference is with a $100 multiplier the SPY represents $13,000 of the SPY ETF while the SPX represents $130,000 of market value. To have exposure to $130,000 in market value, you would need to trade 10 SPY options, but only 1 SPX option.
This example shows how to get comparable market exposure from SPY and SPX options:
Buy 1 SPX 1300 call @ 10.00
Buy 10 SPY 130 calls @ 1.00
The net cost of both of the trades would be $1,000 before commission. Commission may be a key to this situation, depending on your broker. It is very possible the commission associated with trading 10 contracts would be higher than that for a single contract. Again, this will depend on the commission structure of your broker.
So when considering an option trade based on an outlook regarding the direction of a broad-based index market, you have two general alternatives - index or ETF options. Both are very liquid instruments that allow you to benefit from a market outlook.
However, there is potential for early assignment on a short ETF option position that may not exist in the case of index options. Also at expiration, the result is a cash payment for index option position versus physical delivery.
The potential tax difference between ETF and index options should be taken into account when deciding how to go about trading a market outlook.
Finally, depending on the index option series, you may be able to express a market opinion on a certain amount of market value using index options in place of ETF options.