Comparing Index Options and Equity Options

Using index options, traders can target the broader market through one trading vehicle. With single-stock equity options, they can drill down into individual stocks. But the differences between the two go beyond that simple distinction.

Index options, such as those tied to the S&P 500^® index (SPX) or Nasdaq-100^® (NDX), allow traders to hedge or speculate on macro trends. These options are settled in cash and tend to be less volatile than options on a single stock because the underlying asset represents a diversified basket of stocks. Equity and ETF options, conversely, are settled in shares of the single underlying equity or the exchange-traded fund (ETF) representing a bundle of company stocks. And unlike ETF and equity options, most index options are European style, meaning they can't be exercised before expiration.

Both index and stock/ETF options can give traders the opportunity for speculation and hedging. Understanding how they work can give traders more tools for managing risk and potentially capturing income.

As their name implies, index options are put and call options based on the value of an underlying index. They are useful for hedging or speculating on broad segments of the market or for generating income through options credit strategies.

• Favorable tax treatment: The IRS considers many broad-based index options to be Section 1256 contracts, qualifying them for 60/40 tax treatment. This means 60% of any gains from the position are taxed at the lower long-term capital gains rate, while just 40% are taxed as short-term capital gains at the ordinary rate. However, one thing to be aware of is that 1256 contracts are subject to mark-to-market rules. This means any contracts open at the end of the tax year must be treated as if they were sold at a fair market value. Because this rule applies whether an option is sold or not, a trader could experience an unrealized gain or loss.
• Cash settlement: All index options are cash-settled, meaning cash (not shares of stock) changes hands when contracts are assigned or exercised. The amount of cash is based on the difference between the strike price of the option and the settlement value of the index at expiration.
• European-style settlement: Options on the SPX and many other indexes settle European style, meaning exercise or assignment can only take place at expiration and not before. This standard settlement prevents early assignment.
• Leverage: SPX options have a 100 multiplier, which provides the potential to offset a substantial decline in the portfolio and can involve a relatively small upfront cost for broad-market exposure, depending on the strike price and expiration date. But just as leverage can magnify gains, it can also magnify losses.
• Post-market trading: Cboe^® index options, such as those on the SPX and Russell 2000^®, trade after hours. Trading in these contracts closes at 3:15 p.m. CT, fifteen minutes after the equity market closes. For SPX options, trading re-opens at 7:15 p.m. CT and continues overnight until 8:25 a.m., five minutes before equity trading opens.

• Mixed tax treatment: The tax treatment of single-stock options is complex and depends on whether the position is long or short, the time period the option was held, and whether it was closed out, exercised, or expired.
• Settlement in shares: When stock options are exercised, the seller of a call option must deliver the shares of the underlying stock/ETF. The seller of a put option must receive shares of the underlying stock/ETF if assigned. Relinquishing the stock, acquiring a stock that is losing value, or chasing a stock price up to deliver at a lower price can add to the costs and risks of an options position.
• American-style settlement: Single-stock equity options have American-style settlement, which means they can be exercised by the option buyer at any time prior to expiration.
• Leverage: One standard options contract has a 100 multiplier, which is a less-expensive way to gain exposure to the performance of a single stock versus purchasing shares. Remember, leverage increases risk while also increasing the potential for return.

Options can be used as a tactic for insulating portions of portfolios against sudden changes in value. For example, a trader who owns a stock or who has exposure to the overall stock market (through an index fund, ETF, or diversified equity portfolio) could consider buying a protective put index option. This strategy approximates a hedge due to its portfolio size and observed betas.

If the stock price or index value falls by enough that the option is in the money by the expiration date, the value of the option may help offset these losses. Conversely, a trader can purchase index calls to simulate a hedge against broader short exposure.

The cost a trader pays for this is the premium paid for the options. These strategies are typically employed tactically based on assumptions of market risk rather than used on an ongoing basis.

Traders looking to take on risk in exchange for potentially profitable moves in the market have many ways to use options. Straightforward bullish positions include buying call options in order to profit if the stock or index increases in value and selling puts on single stocks or stock indexes to generate income if the underlying option stays out of the money.

In fact, speculating by selling out-of-the-money cash-secured puts and covered calls for income is a common income-generating strategy, known as the wheel strategy. A trader writes puts and collects the premium income, maintaining enough money in their account to cover the cost of the shares if the put option is assigned. Then, if assigned the put, the next step is to write out-of-the-money covered calls on those shares to collect income, using the shares in the account for fulfillment in the event the options are assigned. If the stock gets "called away," the trader could then sell another out-of-the-money put and repeat the process.

Both index options and single-stock or ETF options can be part of more complex options positions that can be used to potentially manage the risks of speculation or offset the costs of hedging strategies. Whether used singly or in combination, these contracts may help traders hedge existing positions or pursue potential gains. Although index and equity options have some important differences, they provide a trader more ways to approach to the market.