SPY vs. SPX Options: Pros and Cons of ETF vs. Index Options
After 30 years as a stock broker/manager and market educator, I know of no better way to safely generate substantial monthly income (up to 4-8%/month) than through the specialized technique detailed in the book “The Monthly Income Machine”
That said, the entry and exit “rules” for these income trades differ somewhat depending on whether you use individual stock options, or options on baskets of stocks, i.e. Index Options and most Exchange-Traded Funds (ETFs).
Let’s consider the nature of, and the pros and cons, of each for use in monthly income trades by contrasting them in two ways.
Options on individual stocks vs. “baskets” of stocks (Indexes and ETFs).
Indexes and ETFs on the S & P, the Russell 2000, the Nasdaq, etc. are less volatile (less dramatic moves up and down) than most individual stocks that meet our trade entry requirements.
Consequently, the Index and ETF options (responding to the prices of a basket of stocks) typically provide comparatively smaller premium income than options on many active individual stocks at the same strike price distance from the current market.
Offsetting this factor, the Index and ETF options are less likely than an individual stock to make a strong enough move, percentage wise, to threaten the profitability of a well-chosen income credit spread.
Bottom line: you can use stock, Index, or ETF options for the monthly credit spread trades so long as you recognize they require different entry parameters depending on the “class” of the underlying.
SPY (the ETF) vs. the SPX (the Index option) for S&P based trades.
This question, SPX vs. SPY, comes up frequently, along with the same question relating to: DJX vs. DIA, NDX vs. QQQ, and RUT vs. IWM.
There are two major areas we need to contrast to get at “which is better”: differences in how they trade and tax treatment differences.
SPX, DJX, NDX, and RUT options are Index Options. They are European Style options, which means, among other things, that their monthly “last trading day” is different than those of ETFs. Index options expire on the third Friday of the month, so their last trading day is the Thursday before the third Friday of the month.
SPY, DIA, QQQ, and IWM are ETFs (Exchange Traded Funds) and are American Style options, and both the last trading day and the investor’s expiration day for these options are the same: the third Friday of the month just like options on individual stocks.
This is a critical difference, and not understanding it can cost an investor dearly. With the SPX option, and other Index Options, there could be a major development after the options market closes on the Thursday preceding the third Friday of the month (Thursday is the last trading day)… which ends all trading in those options.
There could then be an overnight development that causes the underlying index to open way up or down the following Friday (expiration day), but the Index option investor is “locked in.” His last trading day has come and gone, but the settlement price of the Index is determined on the basis of Friday’s market action.
Another significant difference between the Index options and the ETF options is that the Index options are “cash settled” and the settlement takes place only on expiration day. ETF options on the other hand can be “assigned” at any time, but rarely would be unless they were in-the-money… and SaferTraders do not remain in positions that reach in-the-money status.
Another trade-related significant difference is liquidity and the related matter of wide or narrow bid-ask spreads. Liquidity of the SPY ETF is much greater than that of its Index counterpart the SPX. Therefore you can typically expect better (more favorable) fills on SPY orders whether you are entering or exiting the position.
Finally, there are differences in size of the contracts. For example, the SPY is 1/10 the size of the SPX; the IWM is 1/10 the size of the RUT; the QQQ is 1/40 the size of the NDX.
This means that you would need to acquire more contracts of the SPY, IWM, or QQQ ETF contracts to equal the value of their index counterparts… and that means you would be paying more in commission for the same “buying power effect.”
However the higher commission disadvantage of the ETFs like SPY may well be more than compensated for by the ETF’s narrower bid-ask spreads, often resulting in better fill prices, and the fact that you can still exit from a position on expiration Friday.
An additional important advantage of the ETF vs. Index approach is that the investor has the opportunity to take advantage of market movement to acquire greater premiums as he accumulates the ETFs at different prices on the way to equaling the buying power effect of a single larger Index.
Tax Treatment Differences
Here there is a substantial plus to Index options. The IRS treats these indexes differently from stocks (or ETFs).
The Index options get special Section 1256 treatment which enables the investor to have 60% of a gain as long term (at a 15% tax rate), and the other 40% treated as short term (at the regular 35% short term capital gains rate) even if the position is held for less than a year.
By contrast, the ETFs are treated as ordinary stocks, and thus if held less than a year, all gains are taxed at the less favorable 35% short-term capital gains rate.
Thus the Index options can be better from a tax standpoint. You should of course consult with your tax advisor to see how these tax implications may or may not be significant in your situation.
Here’s a summary:
SPX, DJX, NDX, RUT
Can exercise only on expiration day
Can enter or exit from position at any time prior to expiration.
Usually have wider bid-ask spread
Last trading day – Thursday before the third Friday of month (day before expiration day)
Expiration day – third Friday of month
Tax treatment – 60% long-term
SPY, DIA, QQQ, IWM
Can exercise any day
Can enter or exit from position at any time prior to expiration.
Usually have narrower bid-ask
Last trading day – third Friday of month
Expiration day – third Friday of month (same as last trading day)
Tax treatment – entirely short term
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