Options Trading: What are Index Options?

Understanding Options Trading

Episode 04 – Index Options

David McGann (00:17):

Hello to all of our viewers. My name is David McGann. I'm a director here at BMO InvestorLine and I'm thrilled to be co-hosting today's webinar, which is an introduction to index options trading. This comes to you as part of our webinar series that seeks to unpack options trading. Be sure to check out our education hub to find other webinars in this series that may be of interest to you. Once again, we'll be joined here with our friends at OptionsPlay, and I'm pleased to introduce Tony Zhang. Tony is chief strategist at OptionsPlay, where he leads development of options trading products, education for investors, and oversees the firm's quantitative options research. He is a frequent contributor to CNBC for analysis on the markets with a specific lens using technical analysis, fundamentals and of course options. We're pleased to have Tony back and I know we have some great content to review today with index options trading, Tony, and with that, I'll hand things over to you.

Tony Zhang (01:11):

Thank you so much, David, and thank you so much for everyone for joining us today. As David said, we are going to be covering the introduction on index options trading today. A very common type of options contract that can be traded in North America. Today, what we really want to make sure is dive into the specifications of an index options contract, how they might be different from some of the other products that you are used to trading, and making sure that you understand how to utilize some of these products and the different types of products that are available for trading when it comes to index options. Now, before we get started, what we are going to discuss here today is purely for education and demonstration purposes. It is not a solicitation or recommendation to buy or sell any of the specific securities that we'll be using today as example purposes.

(02:06):

Let's take a look at what we are going to cover during today's session. First, before we jump into the options side of things, we want to discuss what is an index versus an ETF. Understanding what the key differences between these two are going to help you better understand the differences when it comes to the options contracts themselves. Then we'll dive into looking at index options and ETF options. We'll be looking at the difference in terms of contract specifications and what the difference will be to you as a trader of these two types of option contracts that on the surface might seem very similar, but when we dive into the details, there's actually quite a bit of difference between these types of contracts and to understand those differences of those contracts, one of the key features is understanding the difference between an American style versus European style options. We'll take a look at which one is which and what the differences are. And then we'll discuss what are some of the potential benefits of trading index options versus what limitations you might have when you're trading index options. And then to help you better understand this, we'll take a look at the NASDAQ 100 index options complex, meaning the different types of products that are available, and then take a look at a sample trade to help you better understand the differences in some of the contract specifications that we're talking about during today's session.

(03:35):

Let's kick this off by taking a look at what is an index. Now, at this stage, I think many of you that are viewing this probably have a good sense for what an index is, but let's just review that very quickly. First of all, when we refer to an index, this is simply just a calculation. It's a method to calculate and track a basket of securities to measure the performance of a group of assets. Now, many of you may be familiar with some of the more popular indices that are available that we use to track different segments of the economy, whether that's the S&P 500 to track the broad-based US equity markets, or if you want to look at something a little bit more specific such as the NASDAQ 100 or the Russell 2000 that tracks either technology-focused stocks or small cap stocks. There are thousands and thousands of indices that track different slices and dices of the economy and the market, but they really provide you a performance of how those specific slices of the market is doing from a price perspective.

(04:42):

And one of the key things to remember is that these are simply just calculations. Meaning they are nothing other than a formula and indices, while widely tracked, the indices themselves are actually not tradable. You cannot trade an index itself. You can only use them as a way to track the performance of a group of assets or a way to slice the overall market. Now, that doesn't mean that many of us wouldn't want to trade some of these indices such as the S&P 500 and the NASDAQ or the Russell 2000, and that's really why the invention of an ETF is such a popular tradable product these days. Because an ETF gives us an instrument that can actually trade a basket of securities that can be bought or sold on an exchange that tracks these popular indices that we all use on a daily basis when we're trading the markets to gauge the performance of the markets. So as I said before, the S&P 500 or the NASDAQ 100, some of the most widely tracked indices, there are many times dozens of ETFs that are listed that track a single index. These could be different providers, these could be different fee models, but they're all doing the same thing to help you try to track the basket of securities that you can actually trade in a vehicle called an ETF.

(06:14):

Now, ETFs are very similar to mutual funds from the perspective of they can be traded to track these baskets of securities, but the difference between an ETF versus a mutual fund is that you can trade them intraday unlike a mutual fund where you can only trade them once a day after the close. And like I said, these are typically tracking some of the most widely tracked indices such as the S&P 500 or the NASDAQ 100, but there are actually hundreds of ETFs that you can track. Because there are thousands of indices that track different assets, there are hundreds of ETFs that are listed that allow you to trade different segments of the market. There are sector ETFs that allow you to track specific sectors. There are ETFs that allow you to track specific currencies or specific commodities. So pretty much anything that you can imagine in terms of how you would like to gain exposure to different segments of the market, chances are there is an ETF listed that allows you to gain specific exposure to a specific slice of the overall market.

(07:23):

So that's the evolution that we're going to look at is indices versus ETFs and looking at the options that are listed on these two types of products. In order to understand that, I think the best thing to first understand is the difference between two different types of option contracts. That's American style options and then European style options. Because many of us that might be trading options are probably more commonly aware of what we consider American style options. Because most ETF and stock options are what we call American style options. That means they are exercisable up until the expiration date. You can exercise them at any time before or on expiration date. Versus index options are what we call European style or typically European style. That means that options for index options are typically only exercisable at expiration.

(08:32):

Let's take a step back and think about these two different products. When we talk about ETF and stock options, those are very similar to each other. These are all for physical delivery. What that means is that each option contract gives the buyer the right to either buy or sell the underlying stock or ETF, depending on whether it's a call or a put. And at expiration or anytime before or at expiration, that buyer can choose to exercise their rights and either buy or sell the underlying shares. However, with an index option, these are all options listed on an index by an exchange directly on the index value themselves and these are cash settled options. Which means that even though you can only exercise them at expiration, if you do choose to exercise them as the buyer, you don't actually get delivery or have to take delivery of the underlying security because in this particular case, an index, as we said before, is not a tradable product. Which means that at expiration, if you choose to exercise your call or put then whatever profits and losses you would have from that exercise, you would actually gain or lose that in cash, which is what we call cash settled options.

(10:03):

ETF and stock options are what we call physical delivery, American style options and index options are cash settled, European options. And the difference is both in terms of how they're settled as well as when you can choose to exercise these options, either at expiration or either on or before expiration.

(10:30):

Now diving even further into the specifications of these contracts because these details while seemingly detailed in nature, make a pretty big difference when it comes to trading these contracts, so it's really important that you read the fine print when you're trading these types of contracts and understand the legal ramifications that you have when you're trading these types of products. The next thing I want to talk about are settlements. We talked about the fact that ETF and stock options are physically settled versus cash settled for index options, but one of the things that I think a lot of stock and ETF traders are used to are what we call PN settlement. That means an option contract expires based on the closing price on the day of the expiration date. Meaning if let's say you traded a contract that expires on April 21st, then the settlement of that option is based on the closing price on that day, which is typical for a lot of options contracts that are traded. However, when you're trading index options, while most index options are also PM settled, there are some index option contracts that are what we call AM settled. And what that means is that are actually settled based on not the closing price of that day, but the opening price of that day. And this is interesting because you actually can't trade these contracts past the closing of the previous day then the expiration date.

(12:08):

So if an option expires in the 21st, the last trading day is actually the 20th. However, even though the last day you can trade is on the 20th, the option contracts aren't settled until the very next day. And we're going to look at an example of this to help you better understand that. And I know that that's sounds very confusing for a lot of traders because you have to determine when you can last trade it based on the expiration date, but we'll go through an example and help you better understand that because that is one of I would say, a critical difference between ETF versus index options the lot of traders should be aware of before they start trading their first index option.

(12:52):

And then lastly, when we talk about stock or ETF options, we're used to option contracts referring to 100 shares of the underlying stock or ETF. And when we're trading stock or ETF options, that is the case. But when we're trading index options, because there are no underlying shares or instruments that you can trade, an index option simply represents typically the index value multiplied with a 100 multiplier. So if you have a $5,000 index value, you would multiply that for 500 and that would mean that you would have a notional value of that contract of half a million dollars. And this is something we're going to take a look at some examples as to how to calculate the P&L of an index option based on that $100 multiplier. And not all index options have a 100 multiplier, so it's important that you do your homework and take a look at the different specifications of the contracts that you are trading and exactly what multiplier you have to apply in order to understand the P&L potential of the option contracts that you're trading.

David McGann (14:00):

Tony, I'm going to jump in here. You've done an incredible job here to unpack a lot on really some of the key differences with index options. The fact that they're European style where ETF options that might still be tracking the same indices are American style. And so why would some traders select index options versus ETF options or vice versa to execute their trading strategy? What are some of the drivers or motivations with making this decision or this choice? Can you expand on that a little bit?

Tony Zhang (14:37):

Yeah. Absolutely, David, and thank you so much. And you're absolutely right. We've gone over a lot of details and a lot of what we consider really as almost legal jargon because it really is the fine print of the legal contract that the buyer and seller is engaging in when they're buying or selling one of these contracts. So to help answer your question, I think there are a few different reasons why traders might gravitate towards an index option. And a lot of it is embedded into what we call that European style cash settled nature of index options. And I will say that typically option sellers, if you're selling options, even if just one of the leg of your option strategy is short an option, I would say that a lot of traders prefer the index options route because when you're short an option and you're short in European style option, you don't have what we call early assignment risk.

(15:42):

So you'll never be in a position where let's say you've sold a credit spread or any other type of strategy or even just you sold a simple put option on an index. You won't have a surprise early expiration because those options can't be exercised early. They can only be exercised at expiration. And if you do end up being assigned on a short call or a short put, you don't have to worry about having the capital to be long 100 shares of the underlying stock or short 100 shares of the stock. You just need to have the difference in terms of P&L in your account to settle that transaction. So for those reasons, I tend to find that for a lot of traders that are selling options or have a component of their strategy as selling options, the index options just makes the transaction cleaner and they don't have to worry about early exercise or needing the cash if they do get assigned on that short leg of the option.

(16:41):

On the ETF side, and we'll discuss this a little bit more on some of the other slides, it really comes down to flexibility. ETFs many times, number one, give you different types of exposure that you may not be able to get from an index option because there are not many index options that are necessarily listed. There are a lot more ETFs that you can trade, so you simply just have the ability to get direct exposure to very specific slices of the market that the ETF options provide you that the index options complex may not provide. And also sizing. ETF options tend to have a lot more flexibility when it comes to sizing, so I think for a lot of retail traders, that is an important component to selecting those types of products for their portfolios over the index options. But we will take a look at how the index options world is evolving to fit the needs of retail traders from that last point, and it closes the gap a little bit in certain areas as well.

(17:41):

So with that, let's take a look at further the difference between American versus European style options, which we've already spoken about a little bit in the previous slide. So like I said, most ETF options are what we consider American style versus index options are European, which means that the buyer has the right to exercise at any time prior to expiration for that American style ETF option versus the European options can only be exercised at expiration. And this means that when we're thinking about these types of transactions, when we're trading stock or ETF options only in the money options are subject to auto exercise at expiration versus the European style ones are simply cash settled. You don't need shares or securities to be exchanged between the buyer and seller.

(18:34):

The option seller doesn't have to worry about needing the margin requirements to be long or short the security or potentially be liquidated. It's just a clean transaction at the end, so whatever the P&L of the trade ad expiration that is just simply debited or credited into your account versus the stock or ETF option trader has to worry about either taking physical delivery or needing to buy or sell that specific stock or ETF in their underlying portfolio. Which makes it quite a bit more complicated, especially if you're trading a strategy and you had no intentions of owning the underlying security. So it just adds a lot of complications and many traders have to avoid those complications by closing out a trade well before expiration or well before the expiry date in order to avoid some of those risks. So those are some of the things that index options don't really have to worry about. They can simply hold onto an option strategy no matter, even if they're trading complex strategies with multiple short legs. They don't have to worry about what are the risks with each leg of being assigned early, and they could just hold it to expiration knowing that at the end it'll just be cash settled in their accounts.

(19:53):

We did mention previously that those American style options are typically PM settled, which makes it from my perspective, a lot easier to remember when to close out a trade or when you might want to manage a trade versus some index options, and there's not many in terms of options expirations, but some of them are AM settled. Some of the more popular expirations are AM settled. And this is one that I think has caught some traders off guard, especially those that weren't paying attention to the fine print. And that can be confusing of when is the actual last date that you can trade in AM settled options and what risks do you have to take based on holding some of those contracts to expiration? Because like I said, those American styles that are PM settled, you can hold them all the way through the closing price of the expiration date, but on the European style index options the last tradable date is actually the night before the expiration date. And that can be really confusing for some traders.

(20:55):

So I actually tell a lot of retail traders that are trading these types of index options just to avoid the AM settled options altogether to avoid what we call overnight risk. We're going to take a look at an example of that here in a few minutes to help you better understand what overnight risk involves and how you can actually manage some of those trades if you were to trade an AM settled index option.

(21:26):

This also answers that question that Dave was asking us before is understanding some of the benefits of trading index options versus what limitations you might have in place when you are trading these types of products. Now don't get me wrong, when we talk about index options in terms of sheer volume out of the entire options market, index options account for a very large percentage even though they represent a very small few contracts of the overall listed contracts that are available for trading. So they are immensely, commonly traded when it comes to index options. So some of the key benefits, like I said before, is really the fact that they're cash settled and they're European style. And this tends to favor option sellers because sellers generally want to avoid early assignment. They don't want to in the middle of an option contract prior to expiration, be forced to own or be short an underlying security. Index options effectively eliminates that risk altogether. And even at expiration, as you're holding one of these contracts to expiration, if you're trading an American style option that are physically delivered, even if you have an option that's approaching expiration that's out of the money, you still have some risk that the buyer of that option could exercise an option even if it's out of the money at expiration.

(22:56):

So when you're trading index options, you effectively eliminate early assignment risk and exercise risk altogether. And that's really attractive I think for a lot of traders that prefer either purely option selling or there's a component of your option strategy that is short an option and to avoid those risks. And I think that's really key for traders that are trading index options themselves. Now, in addition to that, like I said, these are some of the most commonly traded products in the world. So if you think about in the US we list over a million strikes across nearly 6,000 securities that are optionable with a million plus strikes that are available for trading.

(23:42):

Index options represents a very small of the million plus strikes that are available for trading or the million plus option contracts that are available for trading, yet they account for a very large percentage of the overall volume that's traded and that really speaks to the deep, deep liquidity that's offered from many of the index options that you can trade. And we're talking about some of the most popular and most widely tracked indices such as the S&P 500, the NASDAQ 100, the Russell 2000, the VIX. These types of very, very popular indices that we speak almost on a daily basis when we think about the performance of the market, the index options that are listed on those products are some of the most liquid and widely tracked indices, which means that number one, you can trade them with a fair amount of certainty that liquidity will not be a problem as a retail trader because many of these option contracts have billions of notional value that's traded every single day. So plenty of liquidity.

(24:49):

And because of how widely tracked these indices are, they also offer a very, very large number of expiration dates and strike prices. So if you think about how far out you'd like to trade, what percentage out of the money or what delta you specifically like to use for strike prices, from my perspective, there is no other products that provide such a wide range of different expiration dates and strike prices that you'll almost always be able to find an exact expiration date and strike price that you prefer to trade when you're trading these index options versus stock or ETF options where you might not have as many choices of expiration dates and strike prices and you might have to approximate close to what you're looking to trade. So these index options, because of how widely tracked they are and how widely they're traded, offer such a large variety of expiration dates and strike prices that for a lot of traders that really like to fine tune their trading, they can find almost the exact expiration date and strike price they're looking for.

(26:01):

On the flip side, there are not many indices that actually offer index options. There are only about 50 all in the US markets. Out of roughly 6,000 optionable securities, we're talking about less than 1% of them are index options. So that is something to consider that there are not many options when it comes to index options. So you really have the popular indices such as the S&P 500, the Dow, the NASDAQ, the Russell, and maybe the VIX is really the extent of which the major indices that you can trade index options on. There are some in Canada that you can trade as well, but that is the extent of the deep liquidity index options that are available for trading. So you just don't have a wide selection of indices that you can trade these types of contracts on. And contract sizes for these types of index options tend to be more suitable for institutional traders than retail traders.

(27:01):

And we'll take a look at how exchanges are trying to deal with this problem by providing contract sizes that are smaller, better suited for retail traders. But when we talk about the contracts that are most liquid, these are the big contracts. These are many times half a million or $1.5 million contracts in terms of notional value. So they are typically four clients who have a larger account or perhaps institutional traders many times that these index options provide these benefits. But like I said, there are changes that the exchanges are making to try to fit more of these products and make them available for retail traders.

David McGann (27:47):

Tony, I'm going to jump in again and thank you. Like I said in the previous slide or so, lots to unpack with index options and I think one of the big takeaways here ... And I know we have folks in our audience that are very much income-focused and looking to generate income with their portfolios, and I do want to build a bit on what you said, that index options and the fact that they are European style, meaning there isn't that risk of early assignment means that strategies like credit spreads that are typically focused on income generation make index options a great potential vehicle to explore. So I think that's great. I think you've done a wonderful job to unpack that. I've got a couple of questions for you here, Tony. You touched on this a bit already, but I just want to open it up one more time. So number one, you mentioned the fact that there are about 50 indices in the US that have index options listed. Like I said, you touched on this a bit, but do you find that there's high demand and liquidity across the board or is index option trading mostly concentrated across the short list of indices?

Tony Zhang (28:55):

That's a really great question and the short answer to your question is that we see this across the entire options market, not just in index options, but liquidity is very concentrated in the top few names. So we're really talking about the S&P 500, the NASDAQ 100, a little bit of the Russell, but those are really where the liquidity is concentrated in those three index options. So out of the 50 that are listed, those three probably take 70 to 80% of the notional volume that's traded across all index options the same way the top 10 equity names probably account for about 50% of the total volume of the US options markets. So there is concentration across the top names even in the index options as well.

David McGann (29:48):

Okay. Great. And so number two here, Tony, is we've been primarily focused a bit with some of the examples on talking about US index options. And so similarly, is there demand and liquidity with Canadian index options or do we find that it pales in comparison to what we see south of the border with US indices?