Index Options Trading Explained (Guide w/ Visuals)

INDEX OPTIONS ETF OPTIONS EQUITY OPTIONS

Exercise Style:

European
American
American

Settlement:

Cash-Settled
Physical Delivery
Physical Delivery

Tax Advantages:

Has Tax Advantages (60/40)
No Tax Advantages
No Tax Advantages

Dividends:

No Dividends
Dividends
Dividends

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An index option is a derivative financial instrument that gives the buyer the right, but not the obligation, to either buy (call) or sell (put) an underlying index at a specific strike price on an expiration date. 

In the world of options trading, there are three dominating categories of underlying’s upon which derivatives are based:

  1. Equity Option Definition: These types of contracts use a specific stock as their underlying, such as Apple (AAPL) or Tesla (TSLA).
  2. ETF Option Definition: These types of options use exchange-traded funds (ETFs) such as SPY and QQQ as their underlying. The values of ETF options are derived from the physical stock which composes whatever basket of funds that ETF tracks.
  3. Index Option Definition: Index options track “indices” which, unlike ETFs, are not actually comprised of individual stocks, but a non-equity issuing benchmark index, like SPX or NDX.

To differentiate index options from the others on our list, let’s start by looking how these types of options are exercised.

TAKEAWAYS

  • Index options track a non-share issuing underlying index

  • These types of contracts are settled in cash, reducing the large monetary risk that comes with other types of options that are physically settled

  • Index options are “European” style. These types of options can only be exercised at expiration and therefore pose no early-assignment risk to short positions

  • Because of the “60/40” rule, index options benefit from reduced taxation

  • Indices pay no dividends, therefore dividend risk is eliminated in index options.

Index Options: European Style

All options contracts are either settled in the “American” or “European” style. 

  • American Style options allow the owners the right to exercise their call or put option any time before and including the expiration date.
  • European Style options can only be exercised on the day of their expiration. 

All index options are settled in the European style. 

This is great news for traders’ short options. Early assignment risk is virtually removed from index options. 

If you are short a call or short a put option on a stock (like AAPL) or ETF (like QQQ), your long counter-party has the right to exercise this option at any time.

Early exercisement can occur when an options extrinsic value plummets, or when dividends are issued (for calls). Additionally, short options can in theory be assigned at any time. This may not be a bad thing, but it can still be a risk nonetheless. 

With index options, this early-assignment risk is virtually removed. This is one reason professional traders prefer trading options on indices, like SPX (CBOE) and NDX (NASDAQ).

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Index Options: Cash-Settled

Image from CBOE.com

All options contracts are setted either via cash or physical deliver. 

  • Physical Delivery settled options require actual delivery of the underlying product (whether it be stock or ETF)
  • Cash- Settled options simply require an exchange of cash equal to the options notional value at the time of expiration

Index options are cash-settled. 

When an option is exercised (and thus assigned) the short party must produce a lot of capital to hold that position. For equity and ETF options, 100 shares of stock are exchanged per one lot. 

For retails who don’t always watch their accounts closely, this can be huge risk. If you were short a call option on AMZN going into expiration and forgot to buy it back, you would be required to have (at its present value of $3,400) $340,000 in your account! This can result in huge monetary losses.

This is just yet another reason why index options are typically the favorite of professional traders.

Index Options: Tax Advantages (60/40)

Image from CBOE.COM

When compared to equity and ETF options, index options offer investors a pretty substantial tax break. Let’s take a look first at how equity and ETF trades are taxed, then look at the advantages that index options have over them.

Normal Taxation

For investors trading in taxable accounts, both long-term and short-term capital gains must be paid (depending on the position duration). These taxes are often contingent upon an investor’s net income.

  • Short-Term Capital Gains apply to the profits made on positions held for under one year.
  • Long-Term Capital gains apply to profits on positions held for more than one year and are taxed at rates varying from 0% to 20%.

Almost in every situation, paying long-term capital gains is preferred to short-term capital gains. Why? Short-term capital gains are taxed at your normal tax rate. Long-term capital gains are taxed at (lower) rates varying between 0% to 20%.

Index Option Taxation

Index options are taxed a little differently than this. According to section 1256 from IRS.gov, gains on index options are treated at 60% long-term capital gains and 40% short-term. 

Short-term capital gains are almost always higher than long-term capital gains. Sometimes, traders hold positions for over one year just to avoid paying short-term capital gains. 

Section 1256 tells us that no matter how long you hold an index option (be it a minute or year), the profits on these transactions will be taxed at the 60/40 rate. This is quite the monetary benefit indeed!

This is the third way in which index options are superior to equity and ETF options. 

Index Options Eliminate Tracking Error

Tracking Error

The above graph (compliments of the Financial Times) shows how the values of ETFs can deviate from that of the underlying benchmark that they represent. 

This generally isn’t a problem for more liquid ETFs (such as SPY and QQQ), but when you’re trading more exotic ETFs, the performance of the product can sometimes differ from the securities it attempts to represent. ETFs employ fund managers and price stabilizers to keep this price in line, but it doesn’t always work.

Index options track an index without having to worry about acquiring the individual stocks that comprise that index. Therefore, with index options, you know its current market price will (almost) always be 100% in line with its true value. 

Index Options Pay No Dividends

The majority of ETFs and stocks pay dividends. 

This poses a risk to those short options, particularly calls. Since options do not pay dividends, sometimes it makes sense for a party long a call option to exercise their contract. This mostly occurs on options that are deep in-the-money. 

If you are short that option, this will most likely result in a monetary loss to your account. I remember working for an advisor who neglected to trade out of an “ex-dividend” short call position. I also heard about the trader on the floor who decided to “exercise” this long call – it was a lot of risk-free money to him!

Popular Index Options List

  • SPX – S&P 500 Index
  • NDX – NASDAQ 100 Index
  • RUT – Russell 2000 Index
  • DJX – Dow Jones Industrial Average 1/100 Index
  • OEX – S&P 100 index
  • VIX – S&P 500 Volatility Index
  • XEO – S&P 100 (European) Index

Final Word

In summation, we can conclude that index options do indeed offer traders many advantages over other types of options.

  1. Index options eliminate early assignment risk.
  2. These options do not require physical delivery (a risk to neglected short option positions).
  3. Index options offer superior tax advantages.
  4. With index options, dividend risk is removed.

So it seems like index options are all upside. Are there any drawbacks?

Perhaps one of the few disadvantages of index options lays in their strike prices. 

Index options generally have strike prices listed 5 points apart. For smaller retail accounts looking to do small trades (like a one-point vertical spread) this would be an impossibility. 

ETFs on liquid products like SPY, on the other hand, offer even half-point strike prices.

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Mike Martin

Mike Martin

Mike was a writer for projectfinance. He has spent over 15 years in the finance industry, working for such companies as thinkorswim, TD Ameritrade and Charles Schwab. His work has appeared in the Financial Times, the Chicago Sun-Times, and The Buffalo News.

The Best Brokerage for Traders

We’ve been trading with tastyworks for years, benefiting from their trader-friendly fees:

  • Free Stock Trading
  • $10 Commission-Cap Per Option Leg
  • Close Trades for Free*
  • $10 Max Fee Per Crypto Order

Use the link below to check out the tastyworks $100 to $2,000 signup bonus offer.

* Applicable exchange, clearing, and regulatory fees still apply to all opening and closing trades except for cryptocurrency orders which are not subject to exchange, clearing, and regulatory fees.

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