Last updated on February 11th, 2022 , 06:50 am
Options can fall into one of three categories: index options, ETF options, and equity options.
There are a lot of similarities, as well as a lot of important differences between the three types of options.
When compared to the other two option types, index options have the most contrast.
Let’s take a look at a table comparing the three, then jump right into the details!
TAKEAWAYS
- Index options do not allow for “early exercise” and are settled in cash.
- Indices do not offer stock.
- ETF and equity options can be exercised at any time, at which point delivery of the underlying takes place.
- Index options have tax advantages; ETF and equity options have no tax advantages.
- When compared to index options, ETF options have tighter spreads.
- When compared to ETF options, equity options have higher premiums.
| 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 |
Market Index Explained
Index Option Definition: An index option is a financial contract that gives the owner the right, but not the obligation, to buy or sell the value of an underlying index at the specified strike price at expiration.
This article assumes the reader has a basic understanding of call and put options. If you’re brand new to options trading, please check out our comprehensive article entitled “Options Trading for Beginners.”
In the stock market, an “index” measures the price performance of a basket of securities. The most popular indices are those that track major US market sectors, such as the S&P 500 (SPX), the Nasdaq (NDX), and the Dow Jones Industrial Industrial Average (DJX).
However, the breath of indices extends way beyond these products. As stated by sec.gov, there are indices for “almost every conceivable sector of the economy and stock market.”
There are, in fact, thousands of indices in the US alone, covering sub-sectors such as:
- National Indices
- Growth Indices
- Value Indices
- Sector Indices
Index Options Explained
Many indices offer options trading. These are the favorite types of options amongst professional traders. Let’s take a look at a few characteristics to understand why.
1. Index Options Are “European Style”
European style option can only be exercised (and thus assigned) at expiration. All index options are styled in the European fashion.
This is a great benefit for traders’ short options. American style options (like equity and ETF options) can be exercised at any time. When extrinsic value is low, and expiration approaches, assignment is a constant worry for short option holders.
This risk is eradicated with index options.
2. Index Options Are Cash Settled
Though many indices offer options, no index allows for the direct trading of its product.
If you are long an American style option, you have the right to convert that option to stock at any time. But since we just learned there is no trading stock on indices, what are long options converted to for these option types?
Index options are converted to cash upon exercise/assignment.
If at expiration, an index option is in-the-money, a transfer of cash between the long and short parties takes place by this “moneyness” amount to finalize the contract.
EXAMPLE:
SPX Value: 4,700
SPX Call: 4,695
For the above example, the short party would have to provide a cash payment of $500 to the long party at expiration.
Index options eliminate assignment issues related to “pin risk”. Investors who trade index options do not need to worry about waking up the next day to discover several hundreds of shares in their account.
3. Index Options Have Tax Advantages
According to section 1256 from IRS.gov, gains on index options are treated at 60% long-term capital gains and 40% short-term.
This is different from equity and ETF options, of which the short-term gains of both are taxed at the short-term rate. This rate is almost always higher than long-term rates.
Image from CBOE.COM
4. Index Options Pay No Dividends
Since index options have no underlying, no dividends are paid.
This eliminates the “dividend risk” that both ETF and equity call options experience leading up to the ex-dividend date
Exchange-Traded Fund (ETF) Explained
Exchange-Traded Fund Definition: ETFs are underlying issuing securities that track an index, sector, commodity, or other assets.
ETFs have a lot in common with indices, with one important exception: ETFs issue shares.
This share issuance makes things a bit more complicated when compared to index options.
Two of the more popular ETFs are SPDR S&P 500 ETF (SPY) and Invesco’s Nasdaq-100 Index (QQQ).
We remarked earlier that 2 index options also track these same benchmarks. So, what’s the difference?
ETF Options Explained
1. ETF Options Are “American Style”
American style option can be exercised (and thus assigned) at any time. All ETF options are styled in American fashion.
This may be advantageous to long options, but short options face the constant threat of being assigned. Though in reality this rarely happens, assignment is always in the back of the mind of option sellers.
2. ETF Options are Settled via Physical Delivery
Unlike index options, which are settled via a simple transfer of cash, ETF options demand physical delivery of the underlying.
- 1 Long Call Exercised to 100 Long Shares of Stock
- 1 Long Put Exercised to 100 Short Shares of Stock
- 1 Short Call Assigned to 100 Short Shares of Stock
- 1 Short Put Assigned to 100 Long Shares of Stock
Perhaps the greatest risk here is pin risk. If QQQ is trading at $389.92/share in the final moments of trading on expiration day, and you are short the $390 call, who’s to say that QQQ won’t rally in the last seconds of trading, forcing you to deliver a very expensive 100 short shares of stock?
Additionally, short American style options can in theory be assigned at any time.
3. ETF Options Have No Tax Advantages
Unlike index options, ETF options offer no preferential tax treatment – short-term gains are taxed 100% at your short-term tax rate.
4. ETF Options Pay Dividends
Most ETFs pay dividends.
While this isn’t usually a problem for put options, the value of some call options are adjusted to reflect this dividend. Since options pay no dividends, it is sometimes wise for a long call to exercise their contract to capitalize from this payment. Assignment risk is therefore present for short call options with low extrinsic value.
ETF Options Advantage Over Index Options
So now that we have slammed ETF options, perhaps we should say something nice about them.
1. ETF Options Offer Tighter Strike Prices than Index Options.
ETF options often have strike prices one-point and even half a point wide. This makes spread trading easier for smaller accounts.
Index options, on the other hand, typically list their strike prices in 5-point increments. This can make vertical spreads and iron condors very expensive indeed!
2. ETF Options Have the Best Liquidity
When compared to equity and index options, ETF options offer the best liquidity. Not all of them, of course, but many do.
SPY is the most widely traded security in the US. This makes for tight markets, high volume, and high open interest in the options market, which is good for us.
Equities Explained
Equity (Individual Stock) Definition: In the stock market, Equity represents a piece of ownership in an individual company.
If you own a company’s stock, you own a little piece of that company. This allows for two great benefits: voting rights and the right to receive dividends.
Equity Options Explained
In almost every way shape and form, equity options are identical to ETF options.
1. Equity Options Are “American Style”
2. Equity Options are Settled via Physical Delivery
3. Equity Options Have No Tax Advantages
4. Equity Options Pay Dividends
Perhaps the greatest distinction between ETF and equity options lay in their premiums: overall, equity options almost always have more premium than ETF options.
This is because of something called “implied volatility“.
Implied volatility (IV) helps to determine the price of an option. IV is simply the options market’s expected move for a stock. Since equity stocks are less diverse than ETFs, they have more volatility. This risk increases IV, which in turn increases the price of an option.
Final Word
In conclusion, we have learned that index options are very distinct from the options of ETFs and equities.
For the trader who doesn’t wish to stay glued to their computer, index options offer great benefits.
ETF and equity options are best suited for “hands-on”, small accounts.
