The pros and cons of trading index options vs. stock options
Index options and stock options are quite similar, but there are quite notable differences. For instance, with an index option, traders know for a fact whether the position is long or short the market. On the other hand, traders utilizing stock (or equity) options are not dependent on a full market outlook and are instead focused on predicting the direction of a specific underlying stock or equity.
It is common to confuse the index options and stock options and to assume all options are the same, especially for those newer to trading options. After all, it isn’t possible to just trade the S&P 500 Index (SPX) on the market; and the SPX is an index. What exactly is an index, then? An index is a calculation using the weightings of various component groupings like the S&P 500 or the Nasdaq-100 (NDX). Additionally, pricing is automatically calculated based on the changes in price for the components of the index. When trading indexes, it’s important to remember that you are trading options, not shares of the index!
Understanding How Options Contracts Work and Options Trading Essentials
First, what exactly is an option? An option is a contract between two entities, a buyer and seller, that guarantees the product will be delivered at the date of expiration. The delivery is typically related to the value of the underlying asset or component, like equities or indexes.
Understanding How Indexes Relate to the Stock Market
Here are few popular indexes that its critical, as a trader, to be familiar with:
- $SPX – S&P 500 Index
- $OEX – S&P 100 index
- $VIX – Cboe Volatility Index
- $XEO – S&P 100 (European) Index
- $RUT – Russell 2000 Index
- $DJX – Dow Jones Industrial Average 1/100 Index
- $NDX – NASDAQ 100 Index
There are other index options trading on U.S. stock exchanges, but these are rare. Remember that you most likely need to add the “$” ahead of typing in the index symbol when looking these indexes up on a brokerage site.
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Quick Overview: Index Options vs. Stock Options
There are two main components that make an option: the option premium and the strike price. The option premium is the fee paid to purchase the option. With stock/equity options, the strike price is determined by the options seller. If you buy a call option, a specific strike price is offered to you. In contrast, with index options, the strike price is not set by a specific seller and the index option strike price varies based on where the specified stock market trades at the point of purchase.
As most know, there are two types of option: calls and puts. Traders can either buy or sell calls and puts on most major exchanges and brokerage platforms based on his or her trading goals.
Stock/equity options are contracts purchased by traders based on the underlying equity and, when purchased, the options trader either buys or sells the option at a given strike price with an expiration date. After the option(s) expire, the trade is completely closed.
Index options are intended to give traders a chance to benefit from a market move and can also protect a trader’s portfolio holdings. The most significant difference between equity options and index options lies in the component where the options derive value in an index. Index options enable options traders to buy and sell based on broader market performance or specific sector performance. Index options provide traders with an opportunity to pay a small premium compared to the actual contract price.
How does Cash Settlement Differ Between Index Options and Stock Options?
Another critical difference between stock options and index options lies in the settlement process
Let’s start with an example of a stock option. One call option for DIS is about to expire in-the-money. If the trader had not previously sold the stock option prior to the close of the market on the expiration date, 100 shares of DIS are added to his trading account at the strike price.
On the other hand, here is an example of an index option. One call option for SPX is about to expire in-the-money. In this situation, the trader would receive the intrinsic value of the position. If the trader had not previously sold the index option prior to the close of the market on the expiration date, a deposit equivalent to the the intrinsic value of the index option would be made in his trading account.
Are the Settlement Rules Different for Index Options and Stock Options?
The topic of settlement rules can be pretty dull. However, understanding these rules and differences related to the buying and selling of index and stock/equity options is important nonetheless. Traders can end up in trouble with headaches and losses without this necessary information.
Index options can settle based on regular options and weekly option. Regular options are more like a standard stock, with a variety of differences in the weekly options. An index typically settles on Thursday at the market close, based on the first trade being made on Friday. Stock options settle on the third Friday of each month, with the exception of weekly stock options that expire every Friday except the third Friday of each month.
A Simple Comparison of Index Options and Stock Options
Pros:
- Index options offer access to a market with more liquidity.
- Stock options provide you thousands of options with various prices
- Index options offer cash settlements.
- Stock options offer inexpensive price options.
Cons:
- Index options only offer a few choices that are relatively higher priced.
- Index options require more capital in your account.
Summary
For traders, index options and stock options are both essential tools for successful trading and capitalization of your trading portfolio. Index options are utilized for speculation and hedging positions in a liquid, tax-preferential market. Stock options are utilized when traders look to inexpensively purchase a bundle, typically 100 shares, on an equity. While no options are suitable for every trader, both index options and stock options provide extensive trading opportunities to traders of all levels of experience.