ETF Options vs. Index Options: What is the Difference?

ETF Options vs. Index Options: An Overview

In 1982, stock index futures trading began. This marked the primary time traders could actually trade a selected market index itself, relatively than the shares of the businesses that comprised the index. First got here options on stock index futures, then options on indexes, which could possibly be traded in stock accounts.

Next got here index funds, which allowed investors to purchase and hold a selected stock index. The newest burst of growth began with the arrival of the exchange-traded fund (ETF) and has been followed by the listing of options for trading against a large swath of those latest ETFs.

Key Takeaways

  • An exchange-traded fund (ETF) is actually a mutual fund that trades like a stock.
  • ETF options are traded the identical as stock options, that are “American style” and accept shares of the underlying ETF.
  • Index options are settled “European style,” which implies they’re settled in money.
  • Index options can’t be exercised early while ETF options can.

ETF Options Vs Index Options

ETFs and ETF Options

An ETF is actually a mutual fund that trades like a person stock. Consequently, anytime in the course of the trading day, an investor can purchase or sell an ETF that represents or tracks a given segment of the markets. The vast proliferation of ETFs has been one other breakthrough that has greatly expanded the power of investors to reap the benefits of many unique opportunities. Investors can now take long or short positions—in addition to in lots of cases, leveraged long or short positions the next kinds of securities:

  • Foreign and Domestic Stock Indexes (large-cap, small-cap, growth, value, sector, etc.)
  • Currencies (yen, euro, pound, etc.)
  • Commodities (physical commodities, financial assets, commodity indexes, etc.)
  • Bonds (treasury, corporate, munis international)

As with index options, some ETFs have attracted an awesome deal of options trading volume while the bulk have attracted little or no. Figure 2 displays a number of the ETFs that enjoy essentially the most attractive options trading volume on the Cboe.

ETF Ticker
SPDR S&P 500 ETF Trust SPY
iShares Russell 2000 ETF IWM
iShares MSCI  Emerging Markets ETF EEM
SPDR Gold Shares GLD
The Financial Select Sector SPDR Fund XLF
The Energy Select Sector SPDR Fund XLE
SPDR Dow Jones Industrial Average ETF Trust DIA
VanEck Semiconductor ETF SMH
VanEck Oil Services ETF OIH
Figure 2: ETFs with Energetic Option Trading Volume

A reason to think about volume is that many ETFs track the identical indexes that straight index options track, or something very similar. Due to this fact, you need to consider which vehicle offers the perfect opportunity when it comes to option liquidity and bid-ask spreads.

Index Options

The listing of options on various market indexes allowed many traders for the primary time to trade a broad segment of the financial market with one transaction. The Cboe Exchange (Cboe) offers listed options on over 450 domestic, foreign, sector, and volatility-based indexes.

The very first thing to notice about index options is that there is no such thing as a trading occurring within the underlying index itself. It’s a calculated value and exists only on paper. The choices only allow one to invest on the value direction of the underlying index, or to hedge all or some a part of a portfolio which may correlate closely to that exact index.

Key Differences

There are several necessary differences between index options and options on ETFs. Probably the most significant of those revolves across the proven fact that trading options on ETFs may end up in the necessity to assume or deliver shares of the underlying ETF (this will likely or might not be viewed as a profit by some). This just isn’t the case with index options.

The explanation for this difference is that index options are “European” style options and settle in money, while options on ETFs are “American” style options and are settled in shares of the underlying security.

American options are also subject to “early exercise,” meaning that they may be exercised at any time prior to expiration, thus triggering a trade within the underlying security. This potential for early exercise or having to cope with a position within the underlying ETF can have major ramifications for a trader.

Index options may be bought and sold prior to expiration; nonetheless, they can’t be exercised since there is no such thing as a trading within the actual underlying index. Consequently, there are not any concerns regarding early exercise when trading an index option.

Special Considerations

The quantity of options trading volume is a key consideration when deciding which avenue to go down in executing a trade. This is especially true when considering indexes and ETFs that track the identical, or similar, security.

For instance, if a trader wanted to invest on the direction of the S&P 500 Index using options, they’ve several selections available. SPDR S&P 500 ETF Trust (SPY) and iShares Core S&P 500 ETF (IVV) each track the S&P 500 Index. Each SPY and IVV trade in great volume and in turn enjoy very tight bid-ask spreads. This mixture of high volume and tight spreads indicate that investors can trade these two securities freely and actively.

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