Option trading on index

Trading Stock Indexes Using Futures and Options Markets.

What an Index is and how to chart and trade it.

Experienced traders are aware of the main US, European, and Asian stock indexes, because these are the indexes that are reported in the news. Examples of these indexes include the S&P 500, Dow Jones Industrial Average, FTSE 100, Nikkei 225, CAC 40 and DAX.

The stock indexes cannot actually be traded directly, and are available for information only (as a way to track the performance of a group of stocks). Market data is available for the stock indexes, and they can be charted like any other market, but there is no way to make either a long or short trade on the actual stock indexes. But other financial products, like futures and options contracts, can be used to trade the movements of stock indexes.

What Is a Stock Index?

A stock index is a sampling or collection of stocks that gives an overview of how a specific part of the stock market is performing. For example, a technology stock index will contain several or all technology stocks. The index then moves with the overall performance of the stocks that it holds within it. This index can then be quickly used to monitor how technology stocks are performing currently and over time.

Indexes are popular because they provide information for a basket of stocks, and not just one.

Therefore, they are good analysis tool, as well a good trading tool. As mentioned, they can't be traded directly, but there are products that allow traders to participate in the movements of stock indexes. The S&P 500 is a very popular index among individual and institutional traders, because it provides access to 500 stocks with a single futures or options contract transaction.

Futures and Options Markets.

Whenever we hear a trader mention that they are long on the NASDAQ 100, or short on the S&P 500, they are not actually long or short on the NASDAQ 100 or S&P 500 indexes. They are actually long or short on a futures or options market, such as the NQ futures market or the SPXW options market.

Futures and options that are based upon a stock index are known as derivatives markets, because they are derived from the underlying stock index (underlying because the futures or options contract's value is based on the movements of the index it is based on). There are futures and options markets available for all of the popular stock indexes. Stock index futures and options are some of the most popular markets for short term and longer term traders alike.

While these markets can be used by investors, futures and options have an expiry date. Therefore, individual traders typically use these products more for day trading or swing trading.

Charting the Stock Indexes.

Futures and options markets usually move in synchronization with their underlying stock indexes (when the CAC 40 stock index moves down, the CAC 40 futures market moves down). It is therefore possible to chart the stock indexes while trading the futures or options markets.

That said, the futures contracts can also be charted and analyzed.

There are some advantages to charting the stock indexes instead of the futures or options markets. For example, the stock indexes are continuous markets (they do not expire like futures and options contracts do), so traders do not need to update their charting software to a new contract every three months (or monthly depending upon the market in question). Also, the options markets are difficult to chart because they consist of many equally active contracts (with different prices), so charting the stock indexes instead allows a trader to analyze multiple options contracts using a single chart.

If you do decide to chart the stock indexes instead of the futures or options markets, note that you still need to update your trading software (your order entry software) to use the appropriate futures or options contract, when trading, otherwise you may find yourself trying to trade an expired contract and wondering why it isn't working.

Most charting software has a box where you input the symbol you want to chart. If you start typing the name of the index, the index as well as futures or options related to it, will often appear in a drop-down menu. Start typing S&P 500, and you may see SPX, which is a common symbol on most charting platforms for the S&P 500 index (shown on attached chart, along with S&P 500 E-Mini Futures). You may also see varying futures or options products, and you can select them from the list to see a chart of those.

TradingView is a free charting site that provides index and futures charting (along with other products). Type in the name of an index, and then select whether you want to view indexes or futures from the drop-down list.

Final Word on Trading Stock Indexes.

Stock indexes are a popular trading vehicle, but they can't be traded directly. An index is simply a collection of stocks (or other asset) that moves according to the stocks held within it. Traders can analyze both the index and the futures/options contract they are looking to trade. Indexes don't expire, but futures and options contracts do, so traders need to make sure they are trading the appropriate contract.

ETF Options Vs. Index Options.

The trading world has evolved at an exponential rate since the mid-1970s. Fueled in large part by the vast expansion of technological capabilities - and combined with the ability of financial firms and exchanges to create new products to address each new opportunity - investors and traders have at their disposal a vast array of trading vehicles and trading tools. In the mid-1970s, the primary form of investment was simply to buy shares of an individual stock in hopes that it would outperform the broader market averages.

Around this time, mutual funds started to become more widely available which allowed more individuals to invest in the stock and bond markets. In 1982, stock index futures trading began. This marked the first time that traders could actually trade a specific market index itself, rather than the shares of the companies that comprised the index. From there things have progressed rapidly. First came options on stock index futures, then options on indexes, which could be traded in stock accounts. Next came index funds, which allowed investors to buy and hold a specific stock index. The latest burst of growth began with the advent of the exchange-traded fund (ETF) and has been followed by the listing of options for trading against a wide swath of these new ETFs.

An Overview of Index Trading.

A market "index" is simply a measure designed to allow investors to track the overall performance of a given combination of investment instruments. For example, the S&P 500 Index tracks the performance of 500 large-cap stocks while the Russell 2000 Index tracks the movements of 2,000 small-cap stocks. While such market indexes track the "big picture" of price trends, the fact is that for most of the 20th century the average investor had no avenue available to actually trade these indexes. With the advent of index trading, index funds and index options that threshold was finally crossed.

The Vanguard family of funds became the first fund family to offer a variety of index mutual funds, with the most prominent being the Vanguard S&P 500 Index Fund. Other families including Guggenheim Funds and ProFunds took things to an even higher level by rolling out, over time, a wide variety of long, short and leveraged index funds.

The Advent of Index Options.

The next area of expansion was in the area of options on various indexes. The listing of options on various market indexes allowed many traders for the first time to trade a broad segment of the financial market with one transaction. The Chicago Board Options Exchange (CBOE) offer listed options on over 50 domestic, foreign, sector and volatility based indexes. A partial listing of some the more actively traded index options on the CBOE by volume as of September 2016 appears in Figure 1.

The first thing to note about index options is that there is no trading going on in the underlying index itself. It is a calculated value and exists only on paper. The options only allow one to speculate on the price direction of the underlying index, or to hedge all or some part of a portfolio that might correlate closely to that particular index.

An ETF is essentially a mutual fund that trades like an individual stock. As a result, anytime during the trading day an investor can buy or sell an ETF that represents or tracks a given segment of the markets. The vast proliferation of ETFs has been another breakthrough that has greatly expanded the ability of investors to take advantage of many unique opportunities. Investors can now take long and/or short positions - as well as in many cases, leveraged long or short positions - in the following types 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 a great deal of option trading volume while the majority have attracted very little. Figure 2 displays some of the ETFs that enjoy the most attractive option trading volume on the CBOE as of September 2016.

While ETFs have become immensely popular in a very short period of time and have proliferated in number, the fact remains that the majority of ETFs are not heavily traded. This is due in part to the fact that many ETFs are highly specialized or cover only a specific segment of the market. As a result, they simply have only limited appeal to the investing public.

The key point here is simply to remember to analyze the actual level of option trading going on for the index or ETF you wish to trade. The other reason to consider volume is that many ETFs track the same indexes that straight index options track, or something very similar. Therefore, you should consider which vehicle offers the best opportunity in terms of option liquidity and bid-ask spreads.

Difference No.1 Between Index Options and Options on ETFs.

There are several important differences between index options and options on ETFs. The most significant of these revolves around the fact that trading options on ETFs can result in the need to assume or deliver shares of the underlying ETF (this may or may not be viewed as a benefit by some). This is not the case with index options.

The reason for this difference is that index options are "European" style options and settle in cash, 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 can be exercised at any time prior to expiration, thus triggering a trade in the underlying security. This potential for early exercise and/or having to deal with a position in the underlying ETF can have major ramifications for a trader.

Index options can be bought and sold prior to expiration, however they cannot be exercised since there is no trading in the actual underlying index. As a result, there are no concerns regarding early exercise when trading an index option.

Difference No.2 Between Index Options versus Options on ETFs.

The amount of option trading volume is a key consideration when deciding which avenue to go down in executing a trade. This is particularly true when considering indexes and ETFs that track the same - or very similar - security.

For example, if a trader wanted to speculate on the direction of the S&P 500 Index using options, he or she has several choices available. SPX, SPY and IVV each track the S&P 500 Index. Both SPY and SPX trade in great volume and in turn enjoy very tight bid-ask spreads. This combination of high volume and tight spreads indicate that investors can trade these two securities freely and actively. At the other end of the spectrum, option trading on IVV is extremely thin and the bid-ask spreads are significantly higher. In choosing between trading SPX or SPY a trader must decide whether to trade American style options that exercise to the underlying shares (SPY) or European style options that exercise to cash at expiration (SPX).

The trading world has expanded by leaps and bounds in recent decades. Interestingly, the good news and the bad news in this are essentially one and the same. On one hand we can state that investors have never had more opportunities available to them. At the same time the average investor can easily be confused and overwhelmed by all of the possibilities that swirl around him or her.

Trading options based on market indexes can be quite profitable. Deciding which vehicle to use - be it index options or options on ETFs - is something that you should give some serious consideration to before "taking the plunge."

What is index option trading and how does it work?

Index options are financial derivatives based on stock indices such as the S&P 500 or the Dow Jones Industrial Average. Index options give the investor the right to buy or sell the underlying stock index for a defined time period. Since index options are based on a large basket of stocks in the index, investors can easily diversify their portfolios by trading them. Index options are cash settled when exercised, as opposed to options on single stocks where the underlying stock is transferred when exercised.

Index options are classified as European-styled rather than American for their exercise. European-styled options may only be exercised upon expiration, while American options can be exercised at any time up until expiration. Index options are flexible derivatives and can be used for hedging a stock portfolio consisting of different individual stocks or for speculating on the future direction of the index.

Investors can use numerous strategies with index options. The easiest strategies involve buying a call or put on the index. To make a bet on the level of the index going up, an investor buys a call option outright. To make the opposite bet on the index going down, an investor buys the put option. Related strategies involve buying bull call spreads and bear put spreads. A bull call spread involves buying a call option at a lower strike price, and then selling a call option at a higher price. The bear put spread is the exact opposite. By selling an option further out of the money, an investor spends less on the option premium for the position. These strategies allow investors to realize a limited profit if the index moves up or down but risk less capital due to the sold option.

Investors may buy put options to hedge their portfolios as a form of insurance. A portfolio of individual stocks is likely highly correlated with the stock index it is part of, meaning if stock prices decline, the larger index likely declines. Instead of buying put options for each individual stock, which requires significant transaction costs and premium, investors may buy put options on the stock index. This can limit portfolio loss, as the put option positions gain value if the stock index declines. The investor still retains upside profit potential for the portfolio, although the potential profit is decreased by the premium and costs for the put options.

Another popular strategy for index options is selling covered calls. Investors may buy the underlying contract for the stock index, and then sell call options against the contracts to generate income. For an investor with a neutral or bearish view of the underlying index, selling a call option can realize profit if the index chops sideways or goes down. If the index continues up, the investor profits from owning the index but loses money on the lost premium from the sold call. This is a more advanced strategy, as the investor needs to understand the position delta between the sold option and the underlying contract to fully ascertain the amount of risk involved.

Index Option Trading.

I've mentioned index option trading in a number of my other pages, especially the trade of the week pages. What does this mean?

You may have heard of index options and been intimidated by the idea. I want to take a page here and cover what an index is and how option on the index compare with regular options.

What is an index?

An index is nothing more than a collection of actual stocks that usually are grouped around some kind of industry sector or commodity. They are often used to gauge the performance of the broad market or the sector or commodity they represent.

Some examples include the $SPX, which is a representation of the valuation of the stocks in the S&P 500. This would be a broad market index. The $SOX, the semiconductor index is an example of a sector index while the $OIX, the oil index is an example of a commodity related index.

The way an index is valued varies. Some indices are what's known as price weighted where the value of the index is essentially the sum of the total value of an equal number of stocks that make up that index. Another approach to valuation is known as capitalization weighing. In this approach, the total capitalization of each of the stocks in the index added together and divided by some divisor amount that reduces that total to some reasonable number.

It is important to understand the difference because this can affect the movement of the index for various stocks, particularly when they are higher priced stocks.

Index options.

Many (but not all) indices trade options. Generally speaking index option trading isn't much different than trading options on stocks. The pricing of the option is derived from the price and volatility of the underlying index. In most cases on contract still represents 100 shares of the underlying index.

There are a few key differences with index options. For the most part, the options we trade on stocks are American style options. Another style of options that is often found in index option trading is European style options.

European style vs American style options.

Here's the bottom line with European style options. The buyer of the contract may not exercise early. What this means for a seller of options is that they don't have to worry about early assignment, a potential problem if a short position gets in the money.

Most (but not all) index options are European style. Examples include options on the RUT (Russell 2000), SPX (S&P 500), NDX (Nasdaq 100), DJX (Dow Jones 30). There are many others as well. A more complete list can be found here.

Option Expiration and Settlement.

Unlike most options, which cease trading on the third Friday and expire and settle on Saturday at noon, index options are quite a bit different. Failure to understand the difference between the two can be dangerous to your trading account.

Most index options cease trading on the close of business the third Thursday before the third Friday. Settlement value is calculated based on the Friday morning opening price of each of the components of the index. It is NOT based on the opening tick of the index on that Friday morning, although it may be roughly the same price. The settlement value for each of the indices won't typically be reported until several hours later.

Why does this type of behavior pose potential problems? Let me tell you what happened to one of my trades on the NDX. I had sold a short put spread that was doing very nicely although I hadn't reached my target closing price. Thursday night, the market closed and the NDX was still $20 above my short strike. Friday morning there was some news that caused a sharp sell-off and on the market open, NDX gapped down. That's right, about $25 and now I'm in the money by $5. To make things worse, by mid morning, the market had recovered much of the gap down and the position would have expired out of the money had it settled on Saturday as most options do.

I learned 2 important lessons from this. 1) Know how the options you are trade really behave and 2) Never hold an option until expiration.

Cash Settlement.

Index options are cash settled. That means if an assignment were to take place, I wouldn't be forced to buy or sell the index (depending on whether it's a put or call assignment). I would have to settle in cash. Let me give an example.

Let's say I've sold a naked $550 put on the RUT (not a good idea by the way) with the RUT trading at $580. Let's say that on Thursday's close, RUT is trading at $560 and I've decided to hold through expiration (another bad idea). Friday morning, bad news comes out before the market opens and RUT gaps down $15 has a settlement value of $545.

I won't be assigned shares of the RUT because there is no actual stock. Instead, I will be required to pay the difference between the price I was put the RUT for ($550) and the settlement price ($450). That means I must pay the holder of the option $5 (or $500) for every contract in that position.

Advantages of index options.

With all the issues I listed above, one might wonder why trade index options at all? There are actually some advantages of index option trading.

One advantage with index option trading is that fact that they are European style exercise. That means if ther was a case where the position went against me and I was in the money, I am not in danger of being assigned unless I hold it until expiration.

One of the key advantages of trading broad-based index options is the tax treatment that comes with them. This is not intended to be an authoritative tax discussion, however most broad-based index options fall under the category of Section 1256 contracts. While most other options trading fall under the category of short term capital gains (15%-35%).

Tax treatment for Section 1256 contracts is 60% long term and 40% short term. This will lower the effective tax rate to about 23%. For index option trading in larger volumes, this can make quite a difference.

ETFs as a proxy for the index.

Wouldn't it be nice to have the best of both worlds? That is, the ability to trade against the broader market or specific sector and yet not have the risks associated with index option trading of the indices themselves?

There is a way with ETFs (Exchange Traded Funds). I'm not going to go into the details of what an ETF is except to say that it is essentially a stock that is backed by the stocks or commodities it represents. That's not a 100% accurate description but good enough for the purposes of this discussion. As with anything you trade, understanding the product well before trading is a good idea.

I trade options on a lot of ETF products for several key reasons.

They represent a broad sector or commodity that I want to trade They behave like a stock in almost every way They are usually highly liquid themselves and so the options are often very liquid.

See more on why I trade ETF options.

Just for reference, there is a short list of ETFs, the index they track and some basic characteristics about them.

There are many other ETFs that I like to trade that don't track the broad market indices but rather are sector or regional ETFs. Examples include XLF (Financials), XLE (Energy), EEM (Emerging Markets), and EWZ (Brazilian stocks),

The nice thing about ETFs is that there are groups of them that represent the short side of a trade. This isn't as beneficial for options traders, but it's nice to know they are there anyway.

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