The Trader’s Guide to Index Options

Index options have continued to grow in popularity. Perhaps because they are easy to use, available in highly liquid markets, have favorable tax treatment in some cases, and offer a simple settlement process. Therefore, we’ve dedicated an entire show to help you understand what index options are, how they work, how they are different from equity options, and what you need to be aware of if you decide to start trading them in your portfolio.

What Are Index Options?

  • Index options are tied to a physical index such as the Dow Jones 30 (DJX), the Nasdaq 100 (NDX), the S&P 500 (SPX), or the Russell 2000 (RUT).
  • That physical index doesn’t have any underlying stock or equity component to it.
  • Index options have no underlying security which you can hold. In contrast, equity options can be converted into the underlying securities.
  • Index options provide massive exposure in a single transaction. For example, an at-the-money SPY call option costs about 1/10th of a similar at-the-money SPX call option.
  • This gives investors an easier way to get a lot of exposure through a single series of transactions.

Cash Settlement

  • Since index options don’t actually have underlying securities that they can be converted into, a major difference between index options and equity options is index options are settled European-style, or as a cash settlement.
  • At cash settlement, cash is exchanged in your account for the value of that contract at expiration.
  • If your options contract is worth $1,000 at expiration, you will receive $1,000 of cash that is settled in your account.
  • However, if you have a losing contract that is down $1,000 at expiration, $1,000 will be taken out of your account.
  • This also eliminates the risk of early assignment since the index options can’t be converted early into the underlying equity position.

Dividend Payment

  • Contrary to equity options, index options don’t pay dividends.
  • This means that the dividend assignment risk is also eliminated when trading index options.
  • Cash settlement eliminates early assignment. No dividends on index options removes dividend assignment risk. The main drawback of index options is the large size — if an SPX option is $13,000, the corresponding SPY contract is only $1,300.

Taxes

  • If you can handle the size, taxes are another area where index options become more advantageous than equity options.
  • With regular, equity options, when you have a capital gain and have held the option for less than a year, you are subject to short-term capital gains tax.
  • According to Section 1256, with any index option contract, you can classify the capital gain on index options on a 60/40 split.
  • This means 60% of the gain that you have in an index option can be taxed as long-term capital gains tax, and only 40% has to be taxed as short-term capital gains tax.

The New XSP

  • The CBOE is rolling out this new product called XSP
  • The XSP is an index-style option priced very similar to SPY, the smaller brother of SPX.
  • As more investors trade XSP, it could become a valuable alternative in the future that could be used in exchange of, or in place of, the larger SPX contract for investors looking for smaller contract size.

Why Not Solely Trade Index Options?

  • The idea around trading just index options seems on the outside rational and logical.
  • The reality and the practicality of trading one index product is that if you go through crash-type scenarios or major draw-downs, you put your portfolio at severe limitations to the point at which you may not be able to recover.
  • The concentration risk in trading these index options is very real.

Example: The YES strategy (Yield Enhancement Strategy)

  • The YES strategy was a strategy used by UBS for their high net worth clients where they were simply selling iron condors on the SPX and, in some cases, they used leverage.  
  • This strategy absolutely crashed and burned. The WSJ covered the strategy’s losses here: UBS Faces Client Backlash Over Options Strategy.  
  • Although the strategies themselves were not the problem, using them exclusively on one individual product created the problem. That is why we try to trade diversified, uncorrelated tickers across our portfolio. 

Option Trader Q&A w/ Q

Trader Q&A is our favorite segment of the show because we get to hear from one of our community members and help answer their questions live on the air. Today’s question comes from Q:

If options selling is a business strategy and since we do not have such thing as free lunch in the market, how come option prices don’t fall to make this opportunity go away?

Remember, if you’d like to get your question answered here on the podcast or LIVE on Facebook & Periscope, head over to OptionAlpha.com/ASK and click the big red record button in the middle of the screen and leave me a private voicemail. There’s no software to download or install and it’s incredibly easy.

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About The Author

Kirk Du Plessis

Kirk founded Option Alpha in early 2007 and currently serves as the Head Trader. In 2018, Option Alpha hit the Inc. 500 list at #215 as one of the fastest growing private companies in the US. Formerly an Investment Banker in the Mergers and Acquisitions Group for Deutsche Bank in New York and REIT Analyst for BB&T Capital Markets in Washington D.C., he's a Full-time Options Trader and Real Estate Investor. He's been interviewed on dozens of investing websites/podcasts and he's been seen in Barron’s Magazine, SmartMoney, and various other financial publications. Kirk currently lives in Pennsylvania (USA) with his beautiful wife and three children.