The Nuts & Bolts: Index Options Vs. Stock Options

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Index Options
A lot of people I've been speaking to tell me they like trading credit spreads on stock index options. The main reason they like the index products is that indexes tend to move slower than individual stocks. So if adjustments to a position need to be made, you have some time to make them and the probability of a large gap up or down is less than for stocks.

It seems to make sense; you would generally expect an index, say the S&P 500, to be less volatile than its component stocks. The last few weeks however have shown that the stock indexes can also be quite volatile and sadly, many credit spreaders have given back a large portion of their 2008 profits.

Anyway, it came to my attention that many stock index options traders, including some who have been trading these products for quite some time, are not familiar with the differences between index options and regular stock options. I'm going to try and clear that up.


What Is An Index?
The first question that needs to be answered is what is an index, particularly, a stock index? A stock index is a representation of a group of stock prices by a single numerical average. Since there are many texts that describe index products in great detail, I'll only make a few comments.

Among the better known stock indexes are the Dow Jones Industrial Index, the aforementioned S&P 500, Russell 2000 and the Nasdaq-100. There are many different ways in which the average can be calculated ranging from a simple average, to equal dollar weighted, to capitalization weighted, to much more elaborate and sophisticated methodologies. The important thing to realize though is that the index is just a number; it's not tradable like stock. Okay, yes there are ETFs which in a sense make the indexes tradable, but we're talking about trading options on the indexes themselves, not the ETFs.

Stock Options: American Vs. European Exercise
The first thing we note is that all stock options trading in the United States are American style, meaning they can be exercised at any time. On the other hand, most index options are European style, meaning they can only be exercised at expiration. There are some indexes that have both types of options trading.

An example would be the S&P 100 that has OEX options that trade American style and XEO options that trade European style. European style doesn't imply that if you buy or write an option that you're stuck with it until expiration; you always have the right to sell it or cover the short prior to expiration.

The Multiplier
The next thing we note is that a stock option usually represents 100 shares of stock. Since an index doesn't trade like stock, the underlying deliverable of an index option is generally cash equal to the index value times a multiplier, which is usually 100.

This is called a cash settlement as opposed to a stock settlement. For example, if you own the Oct 900 Call on the S&P 500 (SPX options) and the index value (more on this later) is at 907, you would have 100 x (907 ñ 900) = $700 deposited into your account on the first business day following expiration.

Stock options and index options generally have the same expiration date which is the Saturday following the 3rd Friday of the month. (Options on the Volatility Index (VIX) are a notable exception to this rule and will be the subject of a future article.) However, while stock options trade up until the close of trading on Friday prior to expiration, index options generally stop trading on the preceding Thursday.

Settlement Values
This next difference is major. The value of a stock option at expiration is based on the closing value of the stock. With index options it's not based on the closing value of the index, but rather on something called the exercise settlement value! This value is needed to determine if an option is in, out or at the money and how much cash will need to be transferred.

These settlement values can be calculated in one of several different ways, but the most common are referred to as either AM settlement or PM settlement. For any particular index you should know how the settlement value is calculated. AM settlement values are calculated based on the opening value of each of the stock components of the index on the day of exercise, while PM settlement values are calculated based on the closing prices of the index's components.

So for a typical index with the last trading day being the Thursday prior to expiration, the AM settlement value would be calculated by taking the opening prices of each stock in the index and then applying the index's formula for the average. Note that the components of the index can open at different times and that if a particular component of the index doesn't open during the day, the last reported price is used in the calculation.

These settlement values are so important that they have their own symbols and are disseminated as soon as they are calculated. Since all the stocks in the index need to be open before the settlement value can be calculated, it may not be disseminated until late in the day or even after the close on the Friday of expiration.

The interesting thing about how the settlement value is calculated is that it is possible that the value is outside of the range where the index trades during the day. As an example, let's look at the range of the Russell 2000 on the Friday of last month's expiration. It opened at 743.74 and was as low as 740.11 and as high as 761.78. However, the settlement index, i.e. the value used to calculate the amount of money that changed hands, was calculated to be 771.41! I received several calls from frustrated credit spreaders who mistakenly thought there was some kind of an error in the calculation.

You may have noted that I used a lot of words like "generally" and "usually" in this article. That's because for almost every rule there are exceptions. The options arena is constantly changing and new products are being introduced all the time. I would suggest that before you actually trade an index product you check with your broker to be sure that the terms and conditions of the options are what you think. Surprises are generally not good and usually have the effect of making your wallet thinner.

As always, if you have any questions about my articles, have suggestions for future topics, or want more information about our options mentoring program, feel free to email me at: sfreifeld@tradingacademy.com or call me at: (888) OTA-2580 ext. 2010.

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