ETF Options vs. Index Options: What's the Difference?

ETF Options vs. Index Options: An Overview

In 1982, stock index futures trading began. This marked the first time traders could actually trade a specific market index itself, rather than the shares of the companies that comprised the index. 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.

ETFs and ETF Options

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 or short positions—as well as in many cases, leveraged long or short positions 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 options trading volume while the majority have attracted very little. Figure 2 displays some of the ETFs that enjoy the most attractive options trading volume on the Cboe.

A 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.

Index Options

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 Cboe Exchange (Cboe) offers listed options on over 450 domestic, foreign, sector, and volatility-based indexes.

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.

Key Differences

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.

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 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.

Special Considerations

The amount of options 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 similar, security.

For example, if a trader wanted to speculate on the direction of the S&P 500 Index using options, they have several choices available. SPDR S&P 500 ETF Trust (SPY) and iShares Core S&P 500 ETF (IVV) each track the S&P 500 Index. Both SPY and IVV 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.