[This article appears in our August 2016 issue of ETF Report.]
For investors and advisors looking to hedge market risk, generate a little extra income or boost growth, options on indexes are a great solution.
But which instrument is the right one to use—index options or options on index ETFs? Since the S&P 500 Index (ticker SPX) is widely regarded as the leading benchmark of the overall U.S. stock market, let's look at options on SPX—an index—and those on the SPDR S&P 500 ETF (SPY | A-97), an ETF that tracks the index.
Options are uniquely flexible financial tools, so implementing investment strategies using either SPX options or those on SPY may allow you to tailor risk and reward better than if you did not use options at all. That said, there are differences between both, and understanding these differences will allow you to be more effective when it comes time to put your investment strategy to work.
The table to the left summarizes the key differences between the two alternatives. We'll discuss the impact below.
Overview Of Differences Between S&P 500 Index Options And Options On SPY ETF
- In this table, we are referring to the "Traditional" SPX options, but we'll talk about some of the innovations in-depth in the body of the article.
- LEAPS are "Long-term Equity AnticiPation Securities"—options with a year or more before expiration.
While it may seem like a minor difference, it is important to note that options on the SPX derive their value from the index itself, whereas options on the SPY derive their value from a security that derives its value from the index itself. This means that all of the issues related to ETF tracking difference and tracking error applies to options on ETFs.
Notional value is the nominal economic value of shares controlled by an options contract. The notional value of SPY options are lower than those of traditional options on the SPX, so SPY may appeal to some individual investors. For example, assuming the S&P 500 Index is at 2,100, the notional value of a single Options SPX options contract would be (2,100 x 100) = $210,000, since the multiplier for SPX options is 100. In other words, one contract of SPX options would represent a nominal economic value of ($2,100 x 100) = $210,000 if the S&P 500 Index were at 2,100.
Assuming the same reference price, the notional value of a single options contract on the SPY would be (210 x 100) = $21,000. However, while traditional SPX options have the large notional values mentioned here, another index-option-product innovation has been to create "mini" S&P 500 Index contracts, ticker XSP, and these are sized similarly to options on the SPY.