Trading Index Options vs. ETF Options

As most readers know, I trade RUT.  Those are options on the Russell 2000 Index.  I've been asked why I don't trade IWM, an exchange traded fund (ETF) that mimics the performance of the same Russell Index. 

IWM trades almost exactly @ 1/10 the price of it's big sister, RUT, and its options have very attractive markets, with the bid/ask spreads being a penny or two wide.  Here's a quote screen from Wed, Apr 22, early in the afternoon:

Those are very attractive markets to trade.  If these are two cents wide, that's equivalent to trading RUT options when the bid/ask spreads are only 20 cents wideHere are the RUT markets a few minutes later.

As you can see, the RUT markets compare favorably with IWM prices.  When the markets were wild, just a few short months ago, I don't know if this was true.  Tighter markets, and the probability of getting much better fills (trade executions) would be a good reason to consider trading the options of IWM rather than RUT.  There is no advantage at this time.

An investor
interested in options on the S&P 500 Index has the choice between
trading SPX options, or its equivalent ETF, SPY.

Are there other considerations for making the decision?

1) Small traders may not want to trade as much as a one-lot in RUT, and can invest smaller sums by trading a few contracts of IWM.

2) IWM options are American style, and RUT options are European style.  If you are not familiar with the important differences between these option styles, check out my previous discussion on this topic.

I prefer trading cash-settled options, so that's a plus for RUT.

On the other hand, those Friday morning settlement prices can be unsettling.  My recommendation is to avoid owning positions into that possible chaos, but not everyone does that.  American style IWM (or SPY) options expire Friday afternoon, and that's one advantage (assuming you don't mind an expiration that occurs 6.5 hours later).   The settlement process is a plus for IWM.

3)  Addendum.  Thanks Income trader and kbluck. One big advantage for trading index options is the 60/40 income tax advantage.  You can claim 60% of the profits as long-term capital gains, and that cannot be done when trading ETF options.

On balance I do not see any substantial advantages to trading the options of the much lower-priced ETF options than trading options on the index.  Don't forget than you would have to trade 10 contracts of the ETF for every one index option – to have the same profit potential.  For most traders, that means commissions would be much higher.  That could be the deciding factor for many.

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20 Responses to Trading Index Options vs. ETF Options

  1. Tyler Craig 04/23/2009 at 8:53 AM #

    Mark,
    One of the advantages to trading IWM options, is you have the ability to buy/sell shares of stock to delta hedge if needed. In my mind this would give you a bit more flexibility (tighter bid-ask spread, less slippage)than using options to hedge. On the RUT your choices are limited to adding on option positions to hedge. I guess the main question would be is it worth having to do 10x the amount of contracts and paying all the extra commission for the added benefit of having underlying shares to play with. Your thoughts?
    Tyler-

  2. Mark Wolfinger 04/23/2009 at 9:00 AM #

    Very good point.
    Not worthwhile for me. One reason is that I prefer not to use ‘stock’ to make adjustments. But it is a viable plan for others.

  3. Income Trader 04/23/2009 at 9:11 AM #

    There is an advantage trading the actual index options versus the ETF and it is regarding taxation. The index options, because they are cash settled as opposed to ETFs which settle as a security, are taxed at 60/40 short term long term capital gains versus the ETF which is taxed at 100% short term. The differences can be substantial…

  4. Mark Wolfinger 04/23/2009 at 9:24 AM #

    Thank you.
    I don’t know how I missed that one.

  5. kbluck 04/23/2009 at 11:41 AM #

    60/40 taxation for section 1256 contracts like RUT is the other way around. 60% long-term, 40% short term. Reported on IRS form 6781 http://www.irs.gov/pub/irs-pdf/f6781.pdf
    This effect is not to be underestimated. If you are in the in the 33% bracket, it can knock your marginal tax rate from 33% to 22%. On let’s say $25k in trading profits, you’ve saved nearly $3k in taxes.
    If you have stock trading losses, you can also use short-term losses from other instruments to offset your short-term gains from index options, potentially skewing the tax treatment even further to the LTCG side.

  6. kbluck 04/23/2009 at 11:46 AM #

    Regarding Tyler’s point about hedging, you can hedge RUT (or IWM, for that matter) with futures such as ER2. The advantage is much lower margin requirements, typically lower commission costs, and, once again, favorable tax treatment.
    Tying this back to my previous comment, if you expect the hedge part of your position to lose money, make it an equity underlying so its all short-term losses. If you expect it to make money, use 1256 contracts.

  7. Mark Wolfinger 04/23/2009 at 11:50 AM #

    Thanks for both comments.
    You are correct.
    But I must confess that I have never traded a futures contract and never consider them.

  8. kbluck 04/23/2009 at 1:14 PM #

    Just as a thought exercise, consider the idea of writing a short straddle ATM. Now, delta neutralize the expiration curve by being long futures when the underlying is above your strike and short futures when it’s below until expiration. Theoretically, this is a risk-free trade; no matter where the market finishes, your futures will offset your ITM side’s losses, the OTM side expires worthless, and you’ll get to keep the premium. You could also do it with any related strategy such as an IC, where you go long or short only when one of your short legs goes ITM.
    Of course, in reality it’s not risk-free. There is always slippage and transaction costs every time the futures have to flip. If the market wanders back and forth across your strike a lot, you can very quickly start losing money from the slippage. There’s also some correlation risk, pin risk if you’re not cash-settled, and the technique is very high maintenance. But if a trader thinks they have a talent for picking strikes where the market is not likely to linger or thrash, it could be a profitable technique.

  9. lynx 04/23/2009 at 1:15 PM #

    Ditto on the tax advantages of RUT. I traded IWM and individual stock options when I first started out. Individual stocks are too volatile for me and the commissions on IWM were killing me after a couple of months. My current broker(OX) also discounts/prorates smaller lots. So 2 RUT IC’s can be sold for $15, while the equivalent 20 contracts of IWM would generate double the commissions and both investments represent the same $2,000 in margin. When you start out small, you have to look at everything. As the account has grown, commisssion are less and less of an issue.
    lynx

  10. Mark Wolfinger 04/23/2009 at 1:30 PM #

    kbluck
    I hate the idea of negative gamma scalping and dislike the idea of getting short below strike and long above srike. But I do see how you would never have a huuge loss. That may be sufficient reason to consider this play.
    I’ve been trading options since the ’70s and used to use stock to hedge. Now that I trade indexes options, I;ve been using options to hedge. Your idea is new to me, and requires some consideration.
    You are accepting negative gamma scalping as the cost of acquiring insurance that prevents a disaster.
    Interesting.
    Here’s my question: When you adjust to ‘delta neutral’ – how often do you do fix those deltas? This does not prevent a disaster, and guarantees a bunch of bad scalps before expiration arrives. Does it really work?
    On the other hand, if you have 20 iron condors, what do you think of the idea of trading 20 futures – not delta neutral – when an option moves ITM? That prevents a disaster (in fact it provides the opportunity for a huge win), but negative gamma scalps can get expensive.
    The high maintenace is a problem. If you miss a single big move, the whole strategy explodes.

  11. kbluck 04/23/2009 at 1:31 PM #

    One of your points in favor of IWM was the small dollar size. You might mention that there exists a 1/10 mini index option for RUT, RMN. For SPX, there is XSP. NDX has MNX. DJX is already size-equivalent to DIA. This allows small traders to try out index options without exceeding their risk comfort levels; they’re also useful for buying insurance for small lot size spreads of the full-size options.
    The spreads are typically much worse than the ETFs, though.

  12. kbluck 04/23/2009 at 1:44 PM #

    It’s not gamma scalping. The delta is neutralized with regard to expiration, not the current market. The position is *always* held to expiration. Since we are only looking at the expiration curve, there is (theoretically) no gamma risk.
    Let’s use an equity example so we can talk shares instead of deltas. For example, if you sell a 5-lot IWM straddle, you’d be long or short 500 IWM shares at all times; long 500 if IWM is above your strike, short 500 if below. Maintain the position until expiration. At expiration, the ITM side will be assigned (barring a pin), and your hedging stock position is neutralized to zero by the assignment. For example, if IWM is above your strike at expiration, you should be long 500, your short calls will be assigned and you’ll be forced to sell 500 at the strike, but you (theoretically) bought the stock at the strike, so you net out zero both cash and stock. You keep the original premium credit from selling the straddle as your profit.
    For anybody who actually wants to try this, though, I can’t emphasize enough that you have to stay on top of the market 24 hours a day, and slippage is very likely to kill you even if you have a robot to help you.

  13. Mark Wolfinger 04/23/2009 at 2:15 PM #

    1) I appreciate your comments and starting this discussion
    2) You don’t have to treat me as if I were an ignoramus and provide an example using 500 shares.
    I misunderstood the first time, concentrating on the phrase ‘delta neutral’ and missing ‘the expiration curve.’
    Thus, this method always prevents a disaster (barring a huge gap that cannot be covered), can reap huge benefits when the strategy is an iron condor, but not a straddle, and the real danger occurs when the index is near the strike. You dare not miss a big move.
    I don’t know if the individual investor (my readers) can handle that. It’s definitely a strategy for experienced traders and those who can be in front of their trading screens all day. Of course a stop loss limits the damage from an initial reversal, but sans a robot (which I lack) there’s no protection when the market reverses again
    3) It’s negative scalping – even if not gamma scalping. You are ‘negative strike scalping,’ to coin a phrase.
    Thanks

  14. kbluck 04/23/2009 at 2:38 PM #

    I apologize if you felt I was “dumbing down” on your account. I was actually thinking of the many traders with stock-trading backgrounds in your audience who might relate better to stocks than futures. After all, the whole point of the article was to introduce index options to those who might more naturally gravitate to equities.
    We are in total agreement that this strategy, while appearing riskless in theory, is in practice very risky and extremely difficult to pull off successfully. It’s offered only as an intellectual curiosity. I don’t personally trade it, although I have papertraded it in the past as a possible program trade. I eventually concluded the slippage risk was just too high.
    I think it’s relevant to your audience in the sense that rookies often get suckered in by strategies that look good on paper, but practical limitations of real-world execution end up killing them. I’ll never forget the day I was rudely introduced to the reality of dividend risk the hard way, despite holding a “risk-free” box spread.

  15. Mark Wolfinger 04/23/2009 at 2:54 PM #

    Good point, stocks are be easier to understand for thsoe of us who don’t use futures.
    Despite the inherent risk of the method you outlined, it has appeal. And it’s flexible.
    A trader doesn’t have to sell the underlying as soon as the strike is breached, nor does one have to go all the way to ‘expiration neutral’
    It’s similar to buying inurance (strangles) when needed, to protect an iron condor.
    Thanks for sharing the idea.
    Ouch on the box!

  16. rluser 04/23/2009 at 4:23 PM #

    Two other points worth considering: for someone trading in smaller sizes, one might trade a 1 lot IC in the full sized index and purchase (long option) insurance (immediately or later) in a mini or ETF.
    Use of either and ETF or futures contract can make for much easier concentration when multiple parts of one’s portfolio need attention at once

  17. rluser 04/23/2009 at 4:24 PM #

    Oh.. heh… what he just said 🙂

  18. Mark Wolfinger 04/23/2009 at 7:10 PM #

    To kbluck and rluser:
    Good idea on using the minis.

  19. gregf 04/24/2009 at 4:45 AM #

    Can someone explain dividend risk please

  20. Mark Wolfinger 04/24/2009 at 8:00 AM #

    Greg,
    In options terminology, ‘dividend risk’ refers to the chances of not collecting the dividend when you have written a covered call.
    More detail in blog post scheduled for tomorrow: