In the options trading world, there are many, many products that can be traded. There are options on individual equities, equity indexes, currencies, commodities, bonds and more. Equity options are very popular — for good reason — but the focus of this article is on basics that all traders must know when trading index options.
Some of the most popular index options are the S&P 500 Index Options (CBOE:SPX), CBOE Volatility Index (CBOE:VIX), Russell 2000 Index Options, the Nasdaq-100 Index (NASDAQ:NDX) and the S&P 100 Index Options (CBOE:OEX).
Here five things you must understand if you want to successfully trade index options:
#1: Options of the large, active indexes trade under what’s called the European style. Options on individual stocks and exchange-traded funds (ETFs) usually are American style.
Failure to understand the differences, can, and almost certainly will, result in a monetary loss at some point in the future.
The major differences are that European options:
- are cash settled — no shares change hands at expiration
- cannot be exercised before expiration
- have a different method for calculating the final closing, or settlement, price at expiration. That settlement price is an imaginary price. It is not a real-world price. It is calculated by using the opening price of each of the stocks in the index on that Friday — and then assumes that each stock is trading at that opening price at the same time when calculating the index value. Be forewarned this can bring some very surprising settlement prices. The value of every option is 100% dependent on that settlement price.
#2: Index options offer a diversified portfolio of stocks to trade.
Except for rare occasions this eliminates the possibility that some surprising news on the underlying asset will cause it to undergo a gap move. This diversity is good for those traders who adopt negative gamma positions and prefer less movement. But this is a negative feature for traders who buy options and love gigantic moves.
#3: Some index options are very actively traded.
That’s good for the retail trader because he/she has an opportunity to trade with the orders of other traders — and is not dependent on trading with the market makers. The advantage typically is that bid/ask differences are narrowed, and that makes it easier to get an improved price for your orders.
NOTE: To have any chance to get a good trade execution, never enter a market order when trading options. Use limit orders. If that idea is foreign to you, ask your broker how to enter limit orders.
#4: There are ETFs that attempt to mimic the performance of the large, actively traded indexes.
Three of the most popular are the SPDR S&P 500 (NYSE:SPY), the iShares Russell 2000 Index (NYSE:IWM) and the PowerShares QQQ Trust (NASDAQ:QQQ). These ETFs construct a portfolio that is as similar to that of the index as possible. These ETFs also have trading expenses and (small) management fees so the correlation is not 100%. But it is close enough for most traders.
WARNING: These ETF options trade all day on the third Friday of the month — the typical American-style expiration Friday — and the larger index options do not (see #5 below for an exception). Thus, these options trade for a longer time and that affects their value, especially as expiration nears.
These ETFs are a fraction of the size of their sister indexes. This is good for the small trader. Whereas the smallest number of index contracts that you can trade is one, it takes 10 ETF contracts to give the (very similar) results of trading one index option. That allows new traders to gain some experience by placing far less money on the line.
- SPY options closely represent 1/10 of a SPX;
- IWM options closely represent 1/10 of a .RUT;
- QQQ options closely represent 1/40 of an .NDX.
#5: Weekly options on the indexes are different from ‘regular’ index options.
For example, the SPX uses the ‘normal’ European-style settlement system where it calculates its closing price by using the opening price of each of the stocks in the index, as described above.
However, the SPX Weekly options — where settlement prices are determined on the 1st, 2nd, 4th and 5th Fridays of the month — are different. They follow the European style, except their settlement values are calculated by using prices at the END of the trading day — and that means there are no possible surprises in the value.
This is a trap for the unwary investor. Sure everyone should always read all the rules about any option that he/she is considering trading. But many investors do not. To some extent it’s the responsibility of our brokers, the options exchanges, and the Options Clearing Corp. to be certain that extraordinary conditions be shouted from the rooftops to alert everyone. But retail traders should be doing their homework and double checking the different aspects of the index options they plan to trade.
This is just a start to what traders need to know to trade index options. The exchanges and the OCC (and probably your broker) offer much more educational material on options trading, virtually all of it for free. Take advantage of these resources if you plan to trade these demanding but potentially rewarding products.
Follow Mark Wolfinger on his Options for Rookies blog.