On the surface, index options and stock options are very similar. Still, there are some differences that traders should be aware of. Understanding these differences can help you avoid making costly mistakes in the future. An ounce of prevention is worth more than a pound of cure.
In this article, we’ll take a closer look at what makes stock options and index options unique.
What are stock options?
A stock option purchaser has the right, but not the obligation, to buy or sell the specified shares at a specified price before the expiration date. Stock options are used primarily for speculation, to bet on large price movements in stocks, or to hedge the risk of stocks, such as future earnings reports.
To better understand how stock options work, consider the example of a call option on Apple stock. Suppose you are interested in March 17 $160 call optioncurrently trading at $2.85.
This option will expire after the close of trading on Friday, March 16th. Suppose the option is in the money at the end of the trade. In that case, the purchaser’s right to purchase Apple for $160 per share is automatically exercised.
The option strike price is $160. In other words, the buyer has the right to buy 100 shares of her Apple stock at $160 per share until maturity.
The option price is $2.85 per share. Still, the options are quoted on his per-share terms, with each stock option representing 100 shares of the underlying stock, resulting in a total cost of $285.00. I know it’s confusing, but the options are quoted this way to provide context. You can quickly look at the $2.85 option price and think: “It costs $2.85 per share to participate in a rise above the $160 strike price through March 17. Is that a good deal?”
This means that the stock option purchaser will have the right to purchase Apple stock at $160 per share at any time through the March 17 expiration date.
What are index options?
Although similar to stock options in most respects, index options have some important differences that traders should be aware of. prize.
An index option buyer has the right, but not the obligation, to buy or sell a particular stock index at a specified price and date. In contrast to stock options, index options can only be exercised on the settlement date. Stock options, by contrast, can be exercised at any time. settlement.
Let’s look at an example of index options, as we did in the Apple Stock Options example. Suppose you are looking at a call option on the S&P 500 Index (ticker: $SPX). You can see that the March 17 expiration call option has a strike price of 4300 call options and is currently priced at $20.00 per contract.
In this case, if the option is in the money (meaning that the S&P 500 Index is trading above 4300) at expiration, the option holder will be paid the cash value of the option. For example, if her S&P 500 is her 4350 at expiration, the option holder will have her $5,000 credited to her trading account. This is because the options are $50 in the money (4350-4300 = 50) and each option contract is his 100 shares of the underlying asset (50 * 100 = 5,000).
In summary, this 4300 call option will be settled in cash, the difference between the strike price of 4300 and the market price at the time of settlement.
Differences between stock options and index options
Option settlement ensures that both the buyer and seller of the option contract fulfill their obligations. For example, the settlement provides that the Apple 160 call option buyer will receive shares at the agreed price of $160 per share. At the same time, the seller is obliged to offer the shares at that price.
However, stock options and index options have slightly different settlement processes.
Index Options: Cash Settlement
Suppose you own a call option with a strike price of 4200 on the S&P 500 index, and the S&P 500 index is 4300 at expiration. Instead of transferring shares like a physical settlement, you simply receive the difference between the strike price and the market price at maturity of $10,000.
Most traders prefer the much easier cash settlement process. You don’t have to worry about assignments or stock exchanges after settlement. All clean with cash transfer.
Stock options: physical settlement
Physical settlement involves the exchange of the actual underlying asset between the option buyer and seller upon settlement of the contract. It is called “physical” because it involves the actual transfer of shares rather than being cash settled, as index options are cash settled.
Suppose you purchase a put option on McDonald’s stock with a strike price of $260. Once the option expires, McDonald’s stock will trade at $266 at expiration. In this case, the option is automatically exercised and the seller of the option must sell 100 shares of McDonald’s stock at $260 per share.
On the other hand, if you were the put option seller and sold the same put option, you would have to sell 100 shares of McDonald’s to the option buyer for $260. If they don’t have the shares to fulfill their quota, the broker will buy them at the market price and use them to fulfill their quota.
Therefore, if you are selling an “uncovered” option and you do not have the shares to fulfill the allocation, it is usually best to close the option prior to settlement.
Index options are more tax efficient
On average, profitable index options have a lower tax burden than comparable stock option trades. This is because index options and stock options are taxed differently.
Stock option trades are taxed like regular stock trades. If the trade is opened for less than one year, those profits are taxed at short-term capital gains rates higher than long-term capital gains rates.
However, Index Options will benefit from being designated as a “1256” contract thanks to Section 1256 of the IRS Code. Regardless of the trading timeframe, these contracts are taxed at the mixed rate. Basically, 60% of the profits are taxed at the long-term capital gains rate and the remaining 40% are taxed at the short-term capital gains rate.
Index options require more capital
Stock indices tend to be priced higher than the average stock price. That means an index option representing his 100 shares of the underlying asset could cost more. For example, a 28-day at-the-money call option on the S&P 500 index could make him a whopping $8,600 since the index is currently at 4,147.
On the other hand, consider the closest stock to the S&P 500 index, the SPDR S&P 500 ETF Trust (also known as SPY). SPY is one-tenth the price of the S&P 500 Index, which is currently 413.98, so a call option with the same strike price would cost only about $860.
But there is a big caveat here. While it’s true that if you want to trade the most liquid and popular index options like $SPX, you’ll need much more capital than your average stock trade, CBOE has recently become popular with undercapitalized traders. Offered many options.
CBOE recently launched mini and nano options on the S&P 500 index. This is 1/10th and 1/100th the size of the SPX option, respectively. For example, an at-the-money call for a mini SPX option is around $860 and the equivalent nano SPX option is around $86.
Note that these small contract sizes are very new and generally not very liquid.
Stock options offer so many choices
According to FinViz, there are 5,343 optionable stocks listed on major US exchanges. In the stock market, stocks double or halve almost every day. Opportunities abound for those willing to navigate smaller, less liquid markets.
On the other hand, in addition to the VIX, there are only a handful of stock indices that mostly move in tandem. There are times when major indices are quiet for long periods of time, and index options offer little opportunity.
For your reference, here is a list of the most popular and active indexing options.
List of index options
● S&P 500 Index ($SPX)
● Mini S&P 500 Index ($XSP)
● Nano S&P 500 Index ($NANOS)
● NASDAQ 100 Index ($NDX)
● Russell 2000 Index ($RUT)
● Dow Jones Industrial Average Index ($DJX)
● S&P 500 Volatility Index ($VIX)
Conclusion
Although similar in many ways to stock options, index options differ in a few key ways, including settlement, expiration, and tax treatment.
Traders looking to maximize their profits in options trading should not limit themselves to the options market in which they started. Stocks, indices, and options on futures each have their own advantages and disadvantages.
Related article