Investors face a number of choices when investing in options. These options include using calls or puts, buying or selling, and what strategies align with their desired outcome and risk tolerance. Before an option trader decides anything, however, they must decide what kind of option to invest in. Index and ETF options differ fundamentally, with varying exposures, liquidity, and more.
Index Options
Most investors are familiar with major indexes such as the S&P 500 or Russell 2000 Index. As such, options traders may look to index options when first investing in options. It’s worth noting that index options express directional price perspectives, as the underlying assets do not trade. They’re also a way to hedge existing portfolio exposures.
One of the fundamental differences between index and ETF options is their styles. Almost all Index options trade “European style,” which can only be exercised at expiration, BMO explained in a video. European-style options trade primarily over-the-counter (not on an exchange) and settle in cash.
Index options can settle in either the morning or the afternoon. Morning settlements use the opening price, while afternoon settlements use the closing price. It’s worth noting that index options cease trading the day before expiration. They carry overnight risk in potential price disparities between the previous day’s closing price and the price used for settlement on the expiration date.
Options investors have a wide range of choices in strike prices and expiration dates on index options. The S&P 500 Index had nearly 18,000 listed strikes stretching all the way to 2033 at the time of the video. “This flexibility has turned index options into some of the most liquid contracts that can be traded on a listed exchange,” BMO said.
Given the size and price appreciation of index constituents over time, an option covering the entirety of the index may prove costly. However, the advent of mini, micro, and nano options provides a lower price point. Generally, these smaller options do not have the same liquidity or number of choices as full index options.
ETF Options
ETF options generally trade in “American style,” which can be exercised at any point before expiration. This means that most ETF options carry early assignment risk or the risk of being exercised before the expiration date.
American options provide greater flexibility over European options, which often translates to higher premiums. American options also trade primarily on exchanges and typically settle in securities, such as stocks, though some settle in cash. The need to hold the underlying stock in some instances of ETF calls and puts may be a determining factor in ETF options investing for some traders. ETF options settle in the afternoon, using the closing price, meaning they avoid overnight risk.
Investing in an ETF option is investing in an underlying asset that trades throughout the day. ETFs cover a range of asset classes with exposure to a vast array of strategies. As such, ETF options provide greater diversification of types of exposures than their index option counterparts. They allow investors to bet not just on directional views but on the performance of asset classes, specific strategies, regional exposures, and more. However, depending on the underlying ETF, ETF options may not be as liquid as index options.
Index options and ETF options offer two different investing experiences. Understanding their fundamental differences may allow an options trader to better align their desired outcome and strategy with the type of option they hold.
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This article is prepared as a general source of information and is not intended to provide legal, investment, accounting or tax advice, and should not be relied upon in that regard. If legal or investment advice or other professional assistance is needed, the services of a competent professional should be obtained. Information contained in this article does not constitute and shall not be deemed to constitute advice, an offer to sell/ purchase or as an invitation or solicitation to do so for any entity. The content of this article is based on sources believed to be reliable, but its accuracy cannot be guaranteed. BMO InvestorLine Inc. and its affiliates, sponsors and employees do not accept responsibility for the content and makes no representation as to the accuracy, completeness or reliability of the content and hereby disclaims any liability with regards to the same. Any strategies discussed, including examples using actual securities, quotes and price data, are strictly for illustrative and educational purposes only and are subject to change without notice. BMO InvestorLine Inc. is not responsible for the information provided and disclaims all liability with regards to the same.
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