One of my favorite options trading strategies is collecting premium on the U.S. stock market and one of the most frequently asked questions that I get from my readers is whether I prefer to trade SPY Options or SPX options?
Unfortunately, there’s no simple answer to this question and instead of giving you my biased opinion, I would rather give you the upside and the downside to trading each one.
To start off, both the SPX and the SPY follow the SP 500 index contract, which tracks the top 500 of the largest publicly traded company in the United States. The SPX is a broad based index, one that’s been available for options traders long before ETF’s began trading.
The first major difference between the SPX and the SPY is the size of the contract. The SPX is 10 times the size of SPY, so if you are a small trader the SPY can be a better way to start, because your risk per trade will be 10 times smaller in comparison to trading the SPX.
If on the other hand you are an experienced trader the SPX may be a better alternative, because you will save substantially on commission, allowing you to buy 10 times the size for the same commission rate.
The one advantage of buying 10 contracts instead of one, is the ability to “average your price” over several different price points, which could potentially offer you a better overall average if you space your accumulation over several hours or even a few days.
Another major difference between the SPY and the SPX is liquidity. ETF’s tend to be more popular than broad based SPX index; and as a result have more liquidity and tighter spread between the bid and the offer. This leads to better price fills on the SPY in comparison to the SPX, and I’ve found that ultimately the money that I saved on commission by utilizing lower number of SPX contracts, was lost in the spread between the bid and the offer, offsetting any savings in commission by trading one SPX contract instead of 10 SPY contracts.
Different Expiration Process
The third major difference between broad based index options and ETF options is the way the options expire. Broad based options such as the SPX utilize the English method of expiration, while all ETF’s, including the SPY adhere to the American exercise method.
Moreover, English style options, such stop trading on the third Thursday of each month, but use the following day’s opening price as the basis for deriving the settlement price. If the price of the index varies greatly between the closing price on Thursday and the opening price on Friday, the price of the option can change greatly and there’s nothing that the trader can do because the option stopped trading one day earlier; so there’s no way to effectively mitigate or decrease the potential adverse price change in the option and as a result the risk on the trade is increased.
Traders can mitigate the risk of English style expiration by closing the position before the options stop trading on Thursday, thereby avoiding any type of risk due to Friday’s potentially adverse movement in the price of the SP 500.
One mitigating factor that English style expiration does bring to the table is the fact that the options settle in cash and there’s no early assignment. This benefits the options seller, because if your option happens to expire in the money, your account will be debited in dollars, and you never have to worry about early assignment, since English options can only be assigned at expiration, which is something I’m going to discuss next.
Risk of Early Assignment
American style expiring options such as the SPY as well as all equity options, can pose a problem for the options seller, because unlike SPX options, American style options settle in shares, so instead of your trading account being debited, you will end up with the actual shares of SPY and you will have to offset them yourself, causing you additional commission and potential risk from holding the shares for limited time. You should keep in mind that exercise can be avoided by offsetting the option before it trades in the money.
Lastly, another inconvenience of American style expiration is the chance of early assignment. While English style options cannot be exercised till option expiration, American style options can be exercised at any time.
I do want to remind you that the only time early exercise becomes an issue is when the option trades in the money and the option has very little time value or premium left. Otherwise, it doesn’t make too much sense for the option buyer to exercise the option, instead of offsetting it for higher price in the market place.
The last and one major overlooked difference between the two types of options is the way they are treated by the IRS.
Index options such as SPX are treated differently from ETF’s and stocks. If you hold stocks or ETF options for less than one year, you are taxed 35% short term capital gain. On the other hand, if you trade broad based index options such as SPX or OEX, you will get different treatment from the IRS.
Even if the position is held for less than one year, there’s a 40/60 split in the way your gains are treated. 60% of a gain is treated as long term (at a 15% tax rate), and the other 40%, is treated as short term (at the regular 35% short term capital gains rate), giving you a substantial benefit in tax savings.
In my personal trading, I tend to use SPX options for longer term trades and hedging and SPY options for shorter term time-frame, because in my opinion the benefit of higher liquidity allows me to attain substantial savings on the cost of the trade, especially when I’m trading spreads; which involves multiple positions and increases the need for tighter spread between the bid and offer.
At times, when liquidity levels are exceptionally strong, I may trade the SPX or the OEX, but I find myself gravitating back to the SPY, since commission rates for options are fairly low and I tend to liquidate options before they trade in the money, eliminating assignment risk the great majority of the time.
Overall, it depends on the strategy and how long I intend to hold the position that dictates which of the two derivatives I intend to use.
Ultimately, deciding between the two different types of derivatives is a matter of risk, liquidity and personal preference. ETF’s began trading in 2005 and before that time, ordinary broad based index options were the only viable choice for speculating or hedging on the S&P 500 or other major indexes such as S&P 100 and the NASDAQ 100.
I hope this short tutorial gave you a better understanding of the difference between broad based index options and ETF’s.