ETF Options vs. Index Options: An Overview
In 1982, stock index futures trading began. This marked the first time traders could actually trade a specific market index itself, rather than the shares of the companies that comprised the index. First came options on stock index futures, then options on indexes, which could be traded in stock accounts.
Next came index funds, which allowed investors to buy and hold a specific stock index. A burst of growth began with the advent of the exchange-traded fund (ETF) and was followed by the listing of options for trading against a wide swath of these ETFs.
Key Takeaways
- An exchange-traded fund (ETF) is essentially a mutual fund that trades like a stock.
- ETF options are traded the same as stock options, which are "American style" and settle for shares of the underlying ETF.
- Index options are settled “European style,” which means they are settled in cash.
- Index options cannot be exercised early while ETF options can.
ETFs and ETF Options
An ETF is essentially a mutual fund that trades like an individual stock. As a result, anytime during the trading day, an investor can buy or sell an ETF that represents or tracks a given segment of the market.
The vast proliferation of ETFs has been another breakthrough that has greatly expanded the ability of investors to take advantage of many unique opportunities. Investors can now take long or short positions—as well as in many cases, leveraged long or short positions in the following types of securities:
- Foreign and Domestic Stock Indexes (large-cap, small-cap, growth, value, sector, etc.)
- Currencies (yen, euro, pound, etc.)
- Commodities (physical commodities, financial assets, commodity indexes, etc.)
- Bonds (treasury, corporate, munis international)
As with index options, some ETFs have attracted a great deal of options trading volume while the majority have attracted very little.
Figure 2 displays some of the ETFs that enjoy the most attractive options trading volume on the Cboe.
| ETF | Ticker |
| SPDR S&P 500 ETF Trust | SPY |
| iShares Russell 2000 ETF | IWM |
| Invesco QQQ ETF | QQQ |
| iSharesMSCIEmerging MarketsETF | EEM |
| SPDRGold Shares | GLD |
| The Financial Select Sector SPDR Fund | XLF |
| The Energy Select Sector SPDR Fund | XLE |
| SPDRDow Jones Industrial AverageETF Trust | DIA |
| VanEck Semiconductor ETF | SMH |
| VanEck Oil Services ETF | OIH |
A reason to consider volume is that many ETFs track the same indexes that straight index options track, or something very similar. Therefore, you should consider which vehicle offers the best opportunity in terms of option liquidity and bid-ask spreads.
Index Options
The listing of options on various market indexes allowed many traders for the first time to trade a broad segment of the financial market with one transaction. The Cboe Exchange (Cboe) offers listed options on over 450 domestic, foreign, sector, and volatility-based indexes.
The first thing to note about index options is that there is no trading going on in the underlying index itself. It is a calculated value and exists only on paper. The options only allow one to speculate on the price direction of the underlying index, or to hedge all or some part of a portfolio that might correlate closely to that particular index.
Key Differences
There are several important differences between index options and options on ETFs. The most significant of these revolves around the fact that trading options on ETFs can result in the need to assume or deliver shares of the underlying ETF (this may or may not be viewed as a benefit by some). This is not the case with index options.
As mentioned, the reason for this difference is that index options are "European" style options and settle in cash, while options on ETFs are "American" style options and are settled in shares of the underlying security.
For an ETF option, one contract size equals 100 shares of the underlying ETF.
American options are also subject to "early exercise," meaning that they can be exercised at any time prior to expiration, thus triggering a trade in the underlying security. This potential for early exercise or having to deal with a position in the underlying ETF can have major ramifications for a trader.
Index options can be bought and sold prior to expiration; however, they cannot be exercised since there is no trading in the actual underlying index. As a result, there are no concerns regarding early exercise when trading an index option.
Special Considerations
The amount of options trading volume is a key consideration when deciding which avenue to go down in executing a trade. This is particularly true when considering indexes and ETFs that track the same, or similar, security.
For example, if a trader wants to speculate on the direction of the S&P 500 Index using options, they have several choices available. SPDR S&P 500 ETF Trust (SPY) and iShares Core S&P 500 ETF (IVV) each track the S&P 500 Index. Both SPY and IVV trade in great volume and in turn enjoy very tight bid-ask spreads. This combination of high volume and tight spreads indicates that investors can trade these two securities freely and actively.
Are ETFs a Good Investment?
Yes, generally, ETFs are a good investment, especially for new investors. They allow exposure to a market sector, gaining access to a wide array of stocks without having to purchase each individual stock. They also reduce the need for having to research many individual stocks. ETFs can be bought and sold easily, just like stocks, and they often come with very low fees, making them an easy and cost-efficient way to invest in the markets.
Are ETFs Safer Than Stocks?
ETFs can be viewed to be safer than stocks simply because they are diversified. Instead of having exposure to one stock, which increases risk, ETFs are exposed to many stocks; so if one does poorly, another may do well, mitigating the loss. That being said, like with any investment, ETFs carry risks, and profits are not guaranteed.
How Can You Invest in an ETF?
To invest in an ETF, simply open an online brokerage account at any of the many available brokerages. From there, deposit money into your account, and then you can start buying ETFs.
The Bottom Line
Whether you purchase ETF options or index options will depend on your investment goals. If you are looking to make a specific trade with the goal of a cash outlay, then an index option is your friend. Conversely, if you are looking to hold shares in an ETF, then you can purchase ETF options.
Article Sources
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Commodity Futures Trading Commission. “CFTC History in the 1980s.”
Investor.gov. "Investor Bulletin: Exchange-Traded Funds (ETFs)."
Options Industry Council. “Trending Options Volume.”
Cboe. "Cboe Global Indices."
Cboe. “ETF Options vs. Index Options.”
Financial Industry Regulatory Authority. "2360. Options."
Financial Industry Regulatory Authority. "Trading Options: Understanding Assignment."
New York Stock Exchange. "Exchange Trade Product (ETP) Options."
Financial Industry Regulatory Authority. "Trading Options: Understanding Assignment."
Cboe. “Getting Started With Index Options.”
Yahoo Finance. "iShares Core S&P 500 ETF (IVV)."
Yahoo Finance. "SPDR S&P 500 ETF Trust (SPY)."
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