Index Trading and Investing VS ETFs
Index options trading
Index trading: I often get asked by members which are better to trade, Indexes or ETFs. “Should I trade SPY or SPX, IWM or RUT, QQQQ or MNX?”
The answer is, it depends. But I do have my preferences.
Both ETFs and Indexes are very liquid. As I write this the At The Money Call in SPX has an open interest of 45,000 contracts. The SPY At The Money Call has an open interest of 85,000 contracts. So both are very liquid. Major hedge funds though trade the indexes because they trade directly with the market makers.
Commissions play a role because the SPX is ten times larger than the SPY. So if you want to trade $1,000 credit spread, you can do it with a 1 contract spread in SPX or a 10 contract spread in SPY. If you are paying per contract, the commission to trade SPY is ten times larger. if you are trading a flat fee per trade, regardless of the number of contracts, then it does not matter which one you choose.
Indexes are European style options which means you cannot get assigned early. There is no early assignment with European options. ETFs are American style options and can be assigned anytime which can screw up your trade.
The Bid/Ask Spreads in ETFs are much smaller than in Indexes. Often times the spreads are only 1 penny. Keep in mind though that a 1 penny spread in an ETF is the same as a 10 cent spread in an Index. And if you have a 5 penny spread in an Index that is better than you can get in an ETF.
As a trader you should never be paying the Bid or the Ask. You should be paying somewhere in the middle. So if the spread is 23/24 you should be paying 23.50 or better.
A wide bid/ask spread can hurt you if the market is going crazy and you need to get out of a position immediately. It also takes a little more finessing to get a good price on a trade. Beginners should stick with ETFs for this reason.
Indexes have preferential tax status. 60% of the income is counted as long term, and 40% is short term no matter how long you were in the trade. For ETFs, the tax implications are the same as stock. Since our option selling trades are concluded in about a month on average, the 60/40 tax structure can save us a lot of money.
Most Indexes are settled on the market open on expiration Friday. ETFs settle at the close on expiration Friday. The Index settlement can cause confusion and crazy settlement prices. That is why it is best not to go into expiration. Take your trades off before and save the heartache.
Indexes are cash secured positions. ETFs are just like stock so if you go into expiration short an option you will be required to buy or sell shares of the ETF. An assignment can easily be remedied but it can cause margin calls and other problems.
Amount of Capital:
With ETFs you can trade spreads with as little as $100. With an Index like the SPX $500 is the minimum. I have heard several traders say that anyone with less than $5,000 should be trading the ETFs, and those with $5k or more should stick to Indexes.
For newer traders with less capital, stick with the ETFs. But I recommend traders start with $10,000. And if you are trading that much or more, the Indexes offer the better bet. As you get better as a trader and your account size grows you may open a portfolio margin account which is margined differently from a regular account. That will really allow you to trade more contracts and the Indexes will allow you to do so without upsetting the market prices with large orders.
Final Score: Indexes 4 points, ETFs 2 points.
My personal opinion: I stick with Indexes because of the commissions, the tax structure, and the ability to trade more money with a smaller number of contracts. I would rather trade 100 contracts than 1,000 and make $100 per spread than $10.
Smaller traders get eaten alive by the commissions when trading ETFs. Once you learn how to enter a trade, the bid/ask spread becomes a non issue. Getting out of a position in a fast moving market can be more difficult but it varies from Index to Index. And if you don’t go into expiration with your trades, the settlement will not affect you either.
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On the “Amount of Capital”, why is it an advantage for trading $500 minimum on Indexes such as SPX instead of as little as $100 on ETFs ?
Good question. Guess I was not clear enough. I will edit the post.
The reason I gave it to the indexes is because as you move up in size, trading more and more money, it is easier to do so in the indexes without upsetting the market. Go into SPY with a 100,000 contract order and you might not get the best prices. Do that in SPX and you can negotiate your prices with the trade desk.
If you are a small trader, then ETFs are better. But when you get to $5,000 or $10,000, which is what I recommend traders start with, I feel the Index is the better way to go.
Because of rate of return on index the math !
What do you mean by saying negotiate with the trade desk?
Any chance you have a feel / knowledge of liquidity diff between /ES vs. SPX? I don’t have portfolio margin, but currently trade /ES to take advantage of SPAN margin. Thanks
That is not something I could answer intelligently. I guess you could look it up, but I do know that SPX is traded in greater volumes off the exchanges than on. /ES has options too but they act a little bit differently than SPX options. Since I have never traded them I am not the one to ask about it. Sorry
I do not know the difference between index and ETFs.
Can you explain please?
An index is a grouping of companies of which an average is taken. thw DOW, S&P 500, Nasdaq, S&P 100, Russell 2000 are all examples of indexes. And ETF is created by a seperate company to track an index or a sector. SPY, DIA, USO, GLD, QQQQ are all etfs. These are more like mutual funds that you can trade like a stock. Indexes are usually larger with more trading volume. You can have an ETF in anything – like the Egypt etf, or a copper etf, but indexes are few. When people ask, “how did the market do?” they are asking about an index.
I did not know about the preferential tax status with indexes. So 60% would be taxed as capital gains and 40% as ordinary income. You just made my weekend! Thanks!
Good point about the bid/ask spread. I’m having trouble getting fills on the indexes as the natural price is so far from the mid. Any suggestions? Otherwise I may switch to etfs in order to get tighter bid/ask and hopefully more fills. Eg. It took me 3 days to get filled on buying SPX 1400/1410 Jun back and most of the time I was at or below the mid. Still waiting on similar fill in NDX. thanks
I have seen that the fill on an etf is roughly about the same as the fill on the index for the comparable strikes/trade. They are wider in indexes, especially SPX, but keep in mind, a 10 cent spread in SPX is 1 cent in SPY.
On the tax treatment, will your broker take care of that for you? I use Think or Swim
Great article! I totally agree, index options have an advantage over ETF options and you outline it very clearly. In favor of index options I would add that they almost always offer a better return over the equivalent ETF, ie., -1 SPX 1420/1430 Call versus -10 SPY 142/143 Call. In favor of ETF, I would add that fills at the Mid price are easier to get.
What about doing a similar comparison between equity options and futures?
Will put it on my list of things to write about.
Great article because I have started trading the indexes w/spreads and find them better than the ETFs. Give me a list of the indexes that you trade on a monthly/weekly basis, my favorite is the RUT. When you mentioned to close your trades off w/Indexes before expiration, did you mean only if they are in the money or close them out regardless? I’m with TOS and I always try to wait to .05 credit so I will not have to pay commissions or are you saying to close it out before .05 credit? Do all of the indexes close on Thursday like the RUT?
You can get a full list at CBOE.com
are some of the more popular ones All are cash based and do the Thursday expire thing. But there are new index options that expire on Friday at the close like regular stock and etf options. Those dont have the same volume yet but they are growing quickly. Eventually people will probably switch over to those so that they know exactly what the final price will be and don;t wait to wait around for the CBOE to figure it out.
What indicators do you use to trade weekly indexes and ETFs or are you using probabilities like the monthly with 1 or 2 Std. deviation? Looked on CBOE.com which are the new index options that you mentioned?
Dont use the technicals much. Still looking for the one or two that give consistent readings.
You made a statement,”The Index settlement can cause confusion and crazy settlement prices. That is why it is best not to go into expiration. Take your trades off before and save the heartache”; my question is close it out even if you are above .05 credit in TOS on that Thursday for the RUT? Just want to make sure I understand because I’ve found that even if you close out early @.05, you still have to pay fees just not commission fees along w/those fees. I closed out one trade @.05 w/20 contracts and had to pay $100(20*.05).
It comes down to risk/reward.
If you are within say 5-10 points in a low volatile market then you can look at exiting before expiration just in case.
If you are very far from the money, you can let them expire. I love letting them expire, but it is better to be safe and pay a little than get burned and pay a lot.
Speaking of Taxes it’s getting to be that time again, so
so you have any feedback on the various tax accounting
software a small trader could use?
The brokers are supposed to make taxes easier on us this year by breaking down all the trades on a new form. Hopefully that will make the record keeping much easier. I let my accountant handle all of it. But since I have optiongenius, I can write off my trading expenses since they relate to the company: software, education, etc.
Appreciate the information.
Allen, are indexes and ETFs about equally “shortable”? Is one group generally more available for borrowing than the other?
Very useful, Allen. Well done, and thanks
How do futures options stack up (/ES)? Higher commissions/fees but lower capital requirements. Not sure if there are any tax benefits.
Futures options have lower commissions a percentage of the gain, similar capital requirements depending on the commodity and volatility at the time, and the same tax benefits as trading Indexes.