Index options based on indices such as the S&P 500 and Nasdaq 100 generally behave the same as equity and futures options, but they also have important differences, especially if you hold them until expiration.
The most obvious difference is the underlying instrument. Index options are based on baskets of stocks rather than a single tradable stock or futures contract. Unlike holders of stock and futures options, who have the right to buy or sell shares of stock or futures contracts, index option holders cannot exercise their options for positions in the underlying index. As a result, index options are ?cash settled,? which means you receive a payment when exercising a long option, and you owe money if you are assigned on a short option position.
Although this process is fairly straightforward, the index options? unique structure determines when you can exercise them (American vs. European style) and when these options expire (AM/PM settlement). Also, there are two different types of index options ? those based on broad indices such as the S&P 500 or Russell 2000, and narrower ones based on specific sectors such as oil, banking, or homebuilding. These option types are taxed differently by the IRS.
Features vary from contract to contract, so it?s a good idea to understand which type of index option you?re trading.
Stock and index option similarities
All equity options have the same characteristics: They represent 100 shares of stock, have American-style exercise, and expire after the close on the third Friday of each month. Options on all exchange-traded funds (ETFs), such as QQQQ and SPY, share the same characteristics.
Index options are less standardized, but their values are calculated with a $100 multiplier. For example, if the S&P 500 index is at 1,310.00 and a May 1,310 call option costs 20, its actual dollar value is $2,000. (By contrast, a futures option represents one contract of the underlying market, so its value is multiplied by that contract?s one point dollar value.)
Unique features of index options:
American- or European-style exercise. Stock options have American-style exercise, which means they can be exercised or assigned anytime before expiration. However, index options can have either American or European-style exercise, whereby options are only exercised/assigned the last day before expiration. Many option sellers prefer European-style options because there?s no risk of assignment ? i.e., option holders can?t exercise their options until the day before expiration.
AM/PM settlement. Index options are settled (have their final value calculated) different ways. Stock options typically settle at the close on the third Friday of the month (PM settlement) before officially expiring the next day (Saturday, although no trading occurs that day). Some index options use this approach, but others have AM settlement, in which case Thursday is the last trading day before expiration, and the final settlement value is based on Friday?s opening prices. Not all stocks trade immediately at the market open, so it frequently takes a few hours to calculate a final settlement value for the index. Also, if you hold an option this long, the market could move significantly overnight, which obviously would affect its final value.
It is imperative to know what you are getting into before becoming involved with a certain index. You must do your homework and check each contract?s specifications which are available at the appropriate option exchanges Web site.
Frank Kneipher
FKPRINTS@YAHOO.COM
