Understanding Index Options

When you do something for a long time, you sometimes fail to appreciate some of its subtleties.  One of those subtleties that I have overlooked is the distinction between index options and equity/ETF options.  There are key differences, some of which become especially critical as we approach monthly and quarterly expirations.  With a quarterly expiration tomorrow, it seems like a particularly opportune time to discuss them.

Even if you don’t trade index options, or even options whatsoever, it is important to understand how expiring index options can create a sort of magnetism around major expirations, attracting or repelling as major indices approach key levels.

A recent podcast taping clarified my thinking on the topic.  I interviewed Kevin Davitt, Nasdaq’s Head of Index Options Content for a brand new IBKR Podcast episode.  In it, Kevin, whose job it is to think about such things, highlights the three key differences between index and equity options.  (While ETFs like SPY and QQQ closely track the indices upon which they are based, their options are part of the broad class of equity options.)

The three key differences between index and equity options are:

1. Index options are cash settled, whereas equity options deliver underlying shares
2. Index options are European style (not subject to early exercise), whereas equity options are American style (can be exercised prior to expiration)
3. Index options can benefit from preferential tax treatment

To that list I would add a “1b”: monthly index options tend to expire at the open on a Friday expiration, while equity options and the more recently listed daily index options expire at the close of trading. 

Without being dismissive of points 2 and 3, those tend to be relevant only to those who trade index products (Please listen to our podcast for more clarity about them).  Point 1 and its corollary are relevant to anyone who wants to better understand what makes markets move.

Cash settled options can be quite desirable for those who want to hedge portfolios because their characteristics more closely match those of insurance policies.  If you buy collision insurance, for example, you pay a fixed premium to protect your auto.  If your car is totaled, the insurance company gives you an amount of money that was contractually agreed upon.  You can use that money to replace your ruined car, or you can simply deposit it in your bank account.  If you don’t utilize the insurance, your premium is gone, but you should hopefully be happy with the fact that you hadn’t been in a serious accident.

Cash settled options work the same way.  If you buy puts struck, say 10% below the market, you have an initial cash outlay that can only be recouped if the market falls below your striking price (if held to expiry).   If the put expires in the money, you receive the difference between the strike price and the official opening price of the index in question[i], which is hopefully more than you paid for the option.  But at that point, you are done.  Your hedge is gone, but your portfolio is unchanged except for the cash differential from the options purchase.  If you had utilized ETF puts held to expiration, you would be obligated to deliver the amount of ETFs specified by the options contract.  You may not want to sell your holdings at that point, or you may not want to establish a short position at the now-lower market price. 

Conversely, an investor who is underweighted but is concerned about missing an upward move can similarly utilize index calls.  If the rally materializes, the call buyer is not obligated to buy shares at now-higher prices, but she may have been able to reap a monetary profit similar to that which a fully invested portfolio would have realized.

You may have noticed that the use cases may seem more appropriate to portfolio managers than individuals.  Although the exchanges have begun to list smaller index contracts (Nasdaq’s XND is one example), the major index contracts can be simply too large for smaller investors.  The face amount of the S&P 500 Index (SPX) contracts is about $390,000 (or 100x the index), while the face amount of the NASDAQ 100 (NDX) contract is a whopping $1.2 million.  These sizes make it relatively easy for a portfolio manager to hedge a significant exposure, but an individual might balk at laying out $12,000 for an at-money, one-month option. 

As a result, the dollar amount of expiring options can be enormous.  For example, there is about $200 million worth of 3,900 strike put and call options expiring tomorrow morning.  That is a huge amount of exposure that can put immense stress on those who are short those options.  And of course, for every long option, there is a short.

Cash settlement can create huge swings for those who are short options and hedging their positions.  As I write this, those 3900 puts in SPX have a roughly -40 delta.  Regardless of whether those options expire in or out of the money, that delta exposure vanishes tomorrow at either zero or 100.  This requires a delicate balancing act for those who are short an expiring near money option.  If the option crosses a strike on expiration, that delta will flip from 0 to 100 or vice versa.  The short holder needs to buy or sell index futures right up to expiration to maintain their hedges.  If they are short options, and hence short gamma, that means that they will need to sell low and buy high – an obviously difficult requirement.

For that reason, many keep a close eye on expiring strikes with high open interest.  Last month, many were concerned that a pre-opening push toward 4300 could cause an upside breakout (the push failed, the breakout never occurred, and a month later we are concerned with strikes about 10% lower).  As I write this, we are currently flirting with the 3900 level, where the combined open interest is about 100,000 expiring contract. 

The combination of high open interest, huge contract sizes, and deltas that vanish because of cash settlement can provide the setup for excess volatility ahead of monthly expirations, culminating with that morning’s pre-market and open.  Whether or not you utilize cash-settled index options, you should understand how they impact markets and volatility nonetheless.

[i] That official opening price often differs from the posted opening price of the index.  The official opening bases its calculation on the opening prices of each of the index’ components, whereas the latter can be simply the first index price displayed by the quote vendor.