3 Reasons to Add Mini Index Options to Your Trading Arsenal
You’ve heard it before: Reduce your investment risks by diversifying your investments and not putting all your eggs in one basket. It’s sound advice that has led many to get broad market exposure through an index exchange-traded fund (ETF), mutual fund, or index futures contract. These products allow traders and investors to target instant diversification. Plus, they can be a way to play the overall market—or a segment of it—with one transaction.
But trading index ETFs or mutual funds means you’ll have to choose between being “bullish,” “bearish,” or simply “flat.” Index options—including Mini-SPX and Mini-RUT options —are different. They open the door for traders to take things to the next level by giving them the ability to:
- Express an opinion on market direction
- Generate income
- Hedge a portfolio of stocks
Options on index ETFs, such as the SPDR S&P 500 (SPY) options, have gained popularity among traders. Yet many are unaware of several potential pitfalls. Many of the dangers exist because these options settle in shares of the ETF itself. But other risks, such as dividend risk and/or early exercise, can catch a trader unaware and cause unique and unwanted complications.
On the other hand, index options like the Mini-SPX and Mini-RUT offer one of the most efficient ways to achieve any of the objectives listed above. They also help potentially avoid some major drawbacks associated with trading index ETFs and/or index ETF options.
Looking for a reason to trade Mini-SPX options? How about three?
1. European Options and Cash Settlement
Heard of “early exercise”? That’s when you hold a short options position, at some point it trades deep in the money, and an option buyer decides to exercise that option at or prior to expiration. When that happens, you’re obligated to sell 100 shares of the underlying security. If a short put is exercised, you’re obligated to buy 100 shares of the underlying security.
On the flip side, if you hold a long call or long put through expiration and it expires in the money, you’ll likely need to buy or sell short shares of the underlying security. Any of these scenarios can give rise to unexpected complications, sometimes when you least expect them.
The culprit? Standard equity and ETF options contracts are deliverable into 100 shares of the underlying, and are what’s known as “American options,” which means they can be exercised at any time prior to expiration.
When trading mini Index options, there’s no threat of early exercise, and no position uncertainty. These options are settled in cash (not shares), so there’s no need to square up positions after expiration. Plus, Mini-SPX options are so-called “European options,” which means they can only be exercised at expiration.
The upshot: European options and cash settlement mean greater certainty in options exercise, expiration, and settlement.
2. Tax Efficiency*
Ever hear of the 60/40 rule? As a mini Index option trader, it can be your friend come tax time.
Traders often don’t think of taxes until it comes time to file them. Typically, index ETFs and mutual funds must be held for 12 months to be taxed as long-term gains. But traders tend to hold positions for less than a year, which means most index ETF and index mutual fund traders are probably paying taxes at the short-term capital gains rate—essentially the ordinary income rate—which can be substantially higher than the long-term capital gains rate.
Gains from trading mini Index options get a hybrid tax treatment. Mini-SPX and Mini-Rut options gains qualify for 60% long-term/40% short-term rates, even if the option is held for less than a year (under section 1256 of the tax code). That is, 60 percent of any gains/losses are treated as long-term gains/losses, regardless of how long you hold the contract. The remaining 40 percent is treated as a short-term gain/loss. This unique feature can offer significant after-tax benefits versus trading an index ETF or index mutual fund.
The upshot: The more gains you generate, the greater the potential tax savings.
3. Dividend Risk Avoidance
Many stock or ETF option traders overlook the potential threat of “dividend risk.” Unfamiliar with the concept? Let’s unpack it.
Before you sell a call on any stock or ETF, it’s important to be aware of any upcoming “ex-dividend date.” Why? If a call option you’ve sold is in the money and the dividend exceeds the remaining time value of the option, there’s a good chance that option will be exercised early (it’s those American options again).
If you’re assigned, you’ll be on the hook to deliver the shares of the underlying security and cash in the amount of the dividend income to the call owner. Many traders have learned this lesson the hard way, having to buy shares to deliver and fork over cash in the amount of the dividend.
It’s not just naked short call options that are subject to dividend risk—covered calls are as well. If you’re long stock or ETF shares against that short call, and you’re assigned, your long position gets called away prior to the ex-dividend date, so you miss out on the dividend.
The upshot: Indices themselves do not pay a dividend, so the threat of dividend risk is eliminated when you trade Mini-SPX options.
Reduce Risks with Mini Index Options
As a trader, success hinges on many factors. Risk management is a big one, but many traders neglect the importance of limiting the risk of unexpected forces and events. By eliminating dividend risk and risk of early exercise, you could focus more on executing your strategy instead of accounting for potential pitfalls. And the preferable tax treatment for Mini-SPX and Mini-Rut options is another great incentive for moving away from buying and selling index ETFs or mutual funds.
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