A Cost-Effective Way to Trade Options on the Russell 2000® Index
Eric Zaba, Derivatives Sales Intern, analyzes the differences between trading Mini-Russell 2000 Index options and iShares Russell 2000 ETF options.
Over the past 12 months, the Russell 2000 Index’s performance has outpaced other market segments, rising 43.53%, compared to the Nasdaq 100 Index, which increased 28.95%, and the S&P 500 Index, which increased 31.08%, in the same time frame, as of the market close on August 25, 2021. As the economy continues its recovery and the proposed U.S. infrastructure bill moves closer to approval, investors looking to express a bullish view of the market may want to consider investment vehicles and strategies that maximize the capital efficiency of their trades.
Russell 2000, S&P 500 and Nasdaq 100 Indices Performance
While most investors choose a product based on contract size and convenience, it’s also important to consider the different capital requirements and potential capital gains tax treatments for each. To understand the importance of these factors, let’s compare the differences between executing a bullish vertical call spread using Cboe’s Mini-Russell 2000℠ Index (MRUT) options and iShares Russell 2000 Index (IWM) exchange traded fund (ETF) options.
A bullish vertical call spread is a risk-defined strategy that enables investors to participate on the upside if there is an increase in the underlying value, while reducing the risk exposure to the net premium paid for the trade. The strategy entails buying a lower-strike call and selling a higher-strike call with the same expiration date. This results in a lower capital outlay than simply purchasing a call or buying shares in the index ETF but puts a cap on potential upside.
Below is a breakdown of a trade using this strategy, in which an investor expects a 10% increase in the Russell 2000 Index and uses a capital outlay of approximately $20,000 in exposure. The chart below shows the return on capital and return after tax, assuming the investor is in the 32% tax bracket.
These hypothetical trades use end-of-day pricing from May 12, 2021 and June 11, 2021. During that time, the Russell 2000 Index increased 9.4%, moving from 2,135.14 to 2,335.81.
Hypothetical Bullish Vertical Call Spread for MRUT and IWM ETF Options
Source: Cboe Global Markets
As illustrated in the trades described above, it’s more capital efficient to trade options on Mini-Russell 2000 Index options than to trade iShares Russell 2000 Index ETF options. Index options like Mini-Russell 2000 Index options may qualify for the 1256 tax code with more favorable 60% long-term/40% short-term tax treatment*, unlike iShares Russell 2000 Index ETF options which are taxed at the ordinary income tax rate. The difference between trading index options and ETF options could potentially save traders thousands of dollars.
Mini-Russell 2000 Index options are also cash-settled with European-style exercise, so accounts are credited or debited in cash at expiration, with no risk of early assignment. Trading ETF options like iShares Russell 2000 Index ETF options can be more complex with physical settlement and American-style exercise as physical delivery of ETF shares and early assignment risk may tie up investor capital or put investor accounts in a margin call.
With potentially better tax treatment and more convenient European-style cash settlement, Mini-Russell 2000 Index options are a cost-effective choice for investors who wish to trade options on the Russell 2000 Index. Gain a new edge with the unique benefits of mini-index options.
*Under section 1256 of the Tax Code, profit and loss on transactions in certain exchange-traded options, including Mini-Russell 2000, are entitled to be taxed at a rate equal to 60% long-term and 40% short-term capital gain or loss, provided that the investor involved and the strategy employed satisfy the criteria of the Tax Code. Investors should consult with their tax advisors to determine how the profit and loss on any particular option strategy will be taxed. Tax laws and regulations change from time to time and may be subject to varying interpretations.
The information in this article is provided for general education and information purposes only. No statement(s) within this article should be construed as a recommendation to buy or sell a security or to provide investment advice. Supporting documentation for any claims, comparisons, statistics or other technical data in this article is available by contacting Cboe Global Markets at www.cboe.com/Contact.
Past Performance is not indicative of future results.
Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of “Characteristics and Risks of Standardized Options.” Copies are available from your broker or from The Options Clearing Corporation at 125 South Franklin Street, Suite 1200, Chicago, IL 60606 or at www.theocc.com.