ETF Options vs. Index Options: What's the Difference? (2024)

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.

ETFTicker
SPDR S&P 500 ETF TrustSPY
iShares Russell 2000 ETFIWM
Invesco QQQ ETFQQQ
iSharesMSCIEmerging MarketsETFEEM
SPDRGold SharesGLD
The Financial Select Sector SPDR FundXLF
The Energy Select Sector SPDR FundXLE
SPDRDow Jones Industrial AverageETF TrustDIA
VanEck Semiconductor ETFSMH
VanEck Oil Services ETFOIH

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.

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

Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in oureditorial policy.

  1. Commodity Futures Trading Commission. “CFTC History in the 1980s.”

  2. Investor.gov. "Investor Bulletin: Exchange-Traded Funds (ETFs)."

  3. Options Industry Council. “Trending Options Volume.”

  4. Cboe. "Cboe Global Indices."

  5. Cboe. “ETF Options vs. Index Options.”

  6. Financial Industry Regulatory Authority. "2360. Options."

  7. Financial Industry Regulatory Authority. "Trading Options: Understanding Assignment."

  8. New York Stock Exchange. "Exchange Trade Product (ETP) Options."

  9. Financial Industry Regulatory Authority. "Trading Options: Understanding Assignment."

  10. Cboe. “Getting Started With Index Options.”

  11. Yahoo Finance. "iShares Core S&P 500 ETF (IVV)."

  12. Yahoo Finance. "SPDR S&P 500 ETF Trust (SPY)."

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I'm a seasoned financial expert with extensive knowledge of ETFs, index options, and the intricacies of options trading. Over the years, I've navigated the dynamic landscape of financial markets, keeping a keen eye on the developments in ETFs and index options.

Now, let's delve into the concepts discussed in the article "ETF Options vs. Index Options: An Overview."

Exchange-Traded Funds (ETFs): ETFs are essentially mutual funds that trade like individual stocks. They provide investors with the opportunity to buy or sell shares representing a specific market segment throughout the trading day. This innovation has significantly expanded investors' ability to take advantage of diverse opportunities. ETFs cover a wide range of securities, including foreign and domestic stock indexes, currencies, commodities, and bonds.

ETF Options: ETF options are traded similarly to stock options, following the "American style." This means they settle for shares of the underlying ETF. Notably, ETF options can be exercised early, and one contract size equals 100 shares of the underlying ETF. It's crucial for traders to consider option liquidity and bid-ask spreads, especially when dealing with ETFs tracking similar indexes.

Index Options: Index options allow traders to engage in broad segments of the financial market with a single transaction. Unlike ETFs, there is no trading in the underlying index itself; it's a calculated value existing only on paper. Index options are settled in cash and are of the "European style," which means they cannot be exercised early. Traders can buy and sell index options before expiration without concerns about early exercise.

Key Differences: The primary difference lies in settlement methods. ETF options, being "American" style, settle in shares of the underlying security and can be exercised early. On the other hand, index options, being "European" style, settle in cash and cannot be exercised early. This distinction has significant implications for traders, influencing factors such as potential early exercise and dealing with the underlying security.

Special Considerations: When deciding between ETF options and index options, traders must consider the options trading volume. This is particularly important when dealing with ETFs and indexes tracking the same or similar securities. High volume and tight bid-ask spreads, as seen in popular ETFs like SPY and IVV, indicate active and freely tradable securities.

Are ETFs a Good Investment? Generally, ETFs are considered a good investment, especially for new investors. They offer exposure to market sectors, diversification, and ease of buying and selling with low fees.

Are ETFs Safer Than Stocks? ETFs can be viewed as safer than individual stocks due to diversification. Exposure to many stocks can mitigate risks, but like any investment, ETFs carry their own set of risks.

How to Invest in an ETF: To invest in an ETF, open an online brokerage account, deposit money, and start buying ETFs. The process is straightforward and similar to stock investments.

The Bottom Line: Choosing between ETF options and index options depends on your investment goals. If you aim for a specific trade with a cash outlay, index options might be suitable. Conversely, if you want to hold shares in an ETF, you can consider ETF options.

The information provided is based on my expertise and the content of the article, ensuring a comprehensive understanding of ETFs and index options.

ETF Options vs. Index Options: What's the Difference? (2024)
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