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ETF Option Trading vs. Index Option Trading

Most options traders including covered call writers are familiar with exchange-traded funds (ETFs) and many trade options on these securities. Many have also heard of, but are not as familiar with, index options. The purpose of this article is to detail the differences between ETF option trading and index option trading.

Definitions

 Exchange-traded fund (ETF):

This is a security that tracks an index, a commodity or a basket of assets but trades like a stock on an exchange. It can be bought and sold throughout the trading day and has price fluctuations as do individual stocks. One major advantage is that these securities provide diversification. Many ETFs have options associated with them and the BCI team provides a weekly ETF Report for our Premium Members showing 15 – 25 eligible ETFs for covered call writing. Below is one of the eight pages found in each report:

Blue Collar Investor ETF Report

Blue Collar Investor ETF Report Exchange-traded funds and covered call writing

 

Index:

This is an imaginary portfolio of securities representing a particular market or segment of a market. The S&P 500 is an example of a commonly used index. Another example is the Russell 2000 Index which tracks 2000 small-cap stocks. Here are a few such indexes that have actively traded options:

  • DJX- Dow Jones Index Options
  • NDX- Nasdaq 100 Index Options
  • SPX- S&P 500 Index options

Note that there is no trading taking place in the underlying index but rather has a calculated value that exists on paper only. Options allow the trader to speculate on price direction.

Mutual funds:

These are professionally managed, diversified portfolios that do not trade like stocks and do not have options associated with them. I include this in the definitions section so that there is clarity about ETFs and Indexes being different from the much more well-known mutual funds.

 

Differences between ETF and Index Options

 

Rights conferred

The holder of an ETF option has the right but not the obligation to purchase our ETF shares whereas the holder of an index option does not. Instead, the holder of an index option has the right to demand the equivalent cash value from the option seller (that’s us) upon exercise of the option. All index options are cash-settled. Here is the formula:

 

Settlement amount = (Difference between index value and the strike price) x $100

Early exercise of American Style options is rare but possible.

 

Style of options traded

When we sell options on stocks or ETFs, we are selling American Style options. This means that they are settled in shares of the underlying security and can be exercised at any time up to expiration (usually 4 PM EST on the 3rd Friday of the month).

When options on indexes are sold, European Style Options are generally used (OEX- S&P 100 Index Options are an exception). These are cash-settled, can be bought and sold prior to expiration but can only be exercised on expiration. There are no concerns for early exercise with index options.

 

Settlement styles

ETF options are settled based on the closing price as of 4 PM EST on expiration Friday (or the Thursday before if Friday is an exchange-recognized holiday). Index options can have an AM Settlement (based on opening prices of the day of exercise) or PM Settlement (based on closing prices on the day of exercise). For European-style index option contracts the last trading day will be the business day (generally a Thursday) preceding the day on which the exercise settlement value is calculated (generally the third Friday of the month unless that day is a holiday).

 

One more factor to consider

Trading volume can be light on many ETFs and therefore should be evaluated before entering a covered call position. The BCI guidelines is that we look for an open interest of 100 contracts or more and/or a bid-ask spread of $0.30 or less. The exchange-traded funds that appear in our Premium Member Reports all have adequate near-the-money open interest as of market close on Friday.

 

Conclusion

Most Blue Collar Investors trade American Style Options on stocks and ETFs. Understanding the difference between American and European Style Options as well as between ETFs and Index Options will only make us better investors as we fulfill one of our mission statements…Education is Power.

 

Wishing Wealth GMI (General Market Index):

We’re adding a 3rd parameter to our market tone summary. Over the years, this site has published the market overview of both BCI and Investor’s Business Daily. We are now adding a 3rd perspective known as GMI developed by Dr. Eric Wish who teaches a stock investment class to finance honors students at The University of Maryland. I like this Index a lot and will publish the type of signal it is alerting us to each week. Here is an overview of the 6 parameters included in this index:

1.  Wishing Wealth 10 Day Successful New High Index Greater than 100.  Follows a “universe” of almost 4,000 actively traded stocks that were $5 or over several months ago.  Uses a screening tool to count the number of these 4000 stocks that hit a new 52 week high 10 days ago and closed today higher than they closed 10 days ago when they made their highs.  In a rising market, traders have the confidence to let strong stocks climb, so they have a successive number of new highs.  In a bear market, anxious traders take profits quickly and stocks tend to gyrate.  Any number above 100 will be a bullish sign.

2.  At least 100 new highs in a day in my 4,000 stock universe.  In a bullish market we should at least have 100 stocks hitting new highs.  Furthermore, when a market has more daily new lows than new highs we really should not be buying growth stocks with the expectation of making a profit.  The odds are simply against us.

3.  Wishing Wealth Daily QQQQ Index Positive.  The QQQQ tracks the 100 largest non-financial stocks in the NASDAQ. Watches QQQ to track the tech stocks, and often trade it or its options.  This index is positive when technical indicators suggest that it is in a rising trend.

4. This next index is similar to #3 above, but is a daily measure of the SPY, an index that tracks the S&P 500 Index.  The SPY is another useful way to buy or sell the market and is an excellent indicator of the general market trend.

5.  The weekly QQQ index is the same as #3 above but is based on the weekly trend.  A change in trend will occur in the daily indicator before the weekly indicator.  In a strong market both the daily and weekly trends will be positive.

6. The IBD Mutual Fund Index comes from the Investor’s Business Daily (IBD) newspaper.  To be positive, this index must be above its 50 day moving average, shown daily.   IBD subscribers can get the full chart by typing in 0muti in the charting function on the IBD home page. I have found that when these growth mutual funds are rising, then I can expect to successfully buy growth stocks.

The Wishing Wealth General Market Index just counts the number of these conditions that are positive and makes a general comment on buy and sell signals:

BUY SIGNAL:  When 2 consecutive days occur above 3 (4-6)

SELL SIGNAL:  When 2 consecutive days occur below 3 (0-2)

My thanks to Dr. Wish for allowing me to share this information with our BCI community.

 

Market tone:

This week’s reports were a mixed bag which included bullish corporate earnings and some bearish housing data:

  • Sales of existing homes rose by 2.6% month-to-month to an 8-month high of 5.04 million units on an annualized basis (4.98 million was expected)
  • Inventory of existing homes remained @ 5.5 months despite an increase of 2.2% in listings due to faster selling time frames
  • Year-to-year sales of existing homes are down by 2.3% in June
  • Year-to-year the median price of existing home sales is up by 4.3% to $223,300
  • New-home sales declined by 8.1% in June wi9th # months of supply increasing from 5.2 in May to 5.8 in June
  • Year-to-year sales of new homes are down by 11.5%
  • Durable goods orders rose by 0.7% in June, better than the 0.5% expected
  • The Consumer Price Index (indicator of inflation) rose by 0.3% in June mainly due to an increase in gasoline prices
  • Consumer prices are up 2.1% year-to-year
  • Initial jobless claims for the week ending July 19th came in @ 284,000, below the 308,000 anticipated

For the week, the S&P 500 remained unchanged for a year-to-date return of8%, including dividends.

 

Summary:

IBD: Uptrend under pressure

GMI: 6/6- buy signal since 4-22-14

BCI: Moderately bullish favoring out-of-the-money strikes 2-to-1

My best to all,

Alan (alan@thebluecollarinvestor.com)

www.thebluecollarinvestor.com

 

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About Alan Ellman

Alan Ellman loves options trading so much he has written four top selling books on the topic of selling covered calls, one about put-selling and a sixth book about long-term investing. Alan is a national speaker for The Money Show, The Stock Traders Expo and the American Association of Individual Investors. He also writes financial columns for both US and International publications along with his own award-winning blog.. He is a retired dentist, a personal fitness trainer, successful real estate investor, but he is known mostly for his practical and successful stock option strategies.

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14 Responses to “ETF Option Trading vs. Index Option Trading”

  1. Barry B July 26, 2014 6:51 pm #

    Premium Members,
    This week’s Weekly Stock Screen And Watch List has been uploaded to The Blue Collar Investor premium member site and is available for download in the “Reports” section. Look for the report dated 07-25-14.

    Also, be sure to check out the latest BCI Training Videos and “Ask Alan” segments. You can view them at The Blue Collar YouTube Channel. For your convenience, the link to the BCI YouTube Channel is:
    http://www.youtube.com/user/BlueCollarInvestor

    Since we are in Earnings Season, be sure to read Alan’s article, “Constructing Your Covered Call Portfolio During Earnings Season”. You can access it at:
    http://www.thebluecollarinvestor.com/constructing-your-covered-call-portfolio-during-earnings-season/

    Best,
    Barry and The BCI Team

  2. Adrian July 26, 2014 10:46 pm #

    Alan, Can you tell me how long after an earnings report comes out should I then be able to look at selling a call option? (wait a day?), and if you say after the volatility subsides then how would I know if it has as each stock is different? (your reply of the OTO orders sound good for an automatic trade, the only concern I have here is that I may want a “rolldown” as my OTO order, but realise after that a “hit a double” may have been better, considering it is executed during my night-time, and I haven’t seen that price now happens to be a above support level. So maybe waiting until my morning is what I should do,- the US market closes at 9am my time so there are a few hours beforehand if this is alright with you?)

    More questions to come soon too. Thanks

    • Alan Ellman July 27, 2014 8:16 am #

      Adrian,

      If a report meets expectations and offers no unexpected guidance there may be no unusual price volatility in which case the stock can be considered immediately after the report. If a report disappoints (may not want to use this security) or positively surprises we view the price chart to see when consolidation begins (price moving sideways). This can occur later in the day after the report comes out or the next day after the initial morning volatility subsides (usually after 11AM ET). Below is a price chart of AAPL showing the initial price volatility and the 2 possible entry points after the report has passed.

      CLICK ON IMAGE TO ENLARGE & USE BACK ARROW TO RETURN TO THIS BLOG.

      Alan

  3. Alan Ellman July 27, 2014 7:05 am #

    APPLE COMPUTER DIVIDEND:

    AAPL last distributed a dividend of $3.29 on 5/8/14 of $3.29/share. Our member report shows an ex-date of 8/7/14 coming up for the next ex-date. The distribution of that dividend will be on 8/11/14.

    Since the shares were recently split 7-for-1, I anticipate a distribution of about $0.47/share or $47 per 100 shares owned. For those of us who have instructed our brokers to re-invest this distribution into additional shares of AAPL, it would mean purchasing approximately 1/2 additional share for every 100 shares owned.

    Shares purchased in less than 100 lot increments cannot be used for covered call writing but they certainly add value to our portfolios.

    Below is a screenshot showing where ex-dividend date data is located in the current premium member “running list” (mid-report).

    CLICK ON IMAGE TO ENLARGE & USE BACK ARROW TO RETURN TO THIS BLOG.

    Alan

    • Lori July 27, 2014 12:21 pm #

      Alan,

      Thanks for your reports…I can wait to get them each week.

      On this report we use a % dividend yeild on 1.90 which comes out to 1.85 per share not 0.47. What am I missing?

      Thanks,
      Lori

      • Alan Ellman July 27, 2014 12:36 pm #

        Hi Lori,

        I’m glad you brought this up because we have had other members in the past ask this question.

        When a company announces a dividend distribution, it is quoted in annualized format. The % dividend yield is determined by dividing that figure by the current market value of the underlying security.

        Since most companies distribute the dividend on a quarterly basis (as does AAPL), we must then divide by 4 to calculate the distribution in any particular quater. So $1.85/4 = $46.25, pretty close to the $0.47/share I alluded to in my comments.

        Alan

  4. Danny July 27, 2014 9:55 am #

    Hi Alan,

    I am a new Premium member and really excited about your program. I have read couple of your books and have a couple questions:

    1. Is there a certain day of the month that is best to enter new 30 day contracts? Is it best to try to get in around the 30 day timeframe?

    2. Why does your stock screen list come out weekly if entering 30 day contracts?

    Thank you.

    Danny

    • Alan Ellman July 27, 2014 9:57 am #

      Danny,

      My greatest success with covered call writing is with 1-month options…by far. Therefore, I establish my positions near expiration Friday of the ending contracts (mainly when I’m rolling my options) or the first few days of the new contracts. The reason is that we are undertaking a short-term obligation and theta (time value erosion of the option premiums) is logarithmic, not linear. Therefore, the longer we wait into the contract the lower our returns will be and premium will substantially deteriorate after the first week of a 4-week contract.

      We re-screen our database of stocks + the IBD 50 each week for our members for situations when exit strategies are used mid-contract and positions are closed. When this occurs, we are offering our members the most up-to-date information for entering secondary positions in the same contract month.

      Thanks for your membership.

      Alan

  5. Elaine Gerhardt July 27, 2014 10:38 am #

    What are leveraged ETFs? Are they optionable as well? What are their pros and cons?

  6. Adrian July 28, 2014 1:13 am #

    Alan, so my understanding here is to wait until the consolidation starts, which I guess could happen from an hour to over a day after the ER. I still think again of my plan of watching charts and putting on trades(as above for after ER’s) would likely be done within the last few hours in my morning before 9am (when US market closes), but please tell me if you think differently on my thoughts about that morning timeframe of mine.(otherwise I’ll guess it’s O.K.)

    – Now a question still about ER’s I have is if the ER’s for stocks in the 1st week turn out bad, or they are good but returns too low, then you say to go through more stocks,- but what if of the ‘under $50’ stocks I choose from(as cheap) there aren’t enough of them because there are bad ER’s and calculations for them too?, what’s the best thing(s) to do here? (this question as you can tell is a bit late – 1st weeks been!) Thanks

    • Alan Ellman July 29, 2014 11:30 am #

      Adrian,

      Most stock prices settle by early afternoon. This gives analysts a chance to read through all the fine print of the report and perhaps spot some “accounting tricks” created to make the report look a bit better. However, if there is a conference call by the Board of Directors, price settlement may not occur until after that call which may be later in the day. The safest play from Australia may be to wait until the next trading day in the US…you won’t lose much time value.

      If you find you need more eligible candidates in the price range you are focusing in on, consider our ETf reports which will add another 20-25 eligible candidates. The returns will be a bit lower but it may help to populate your portfolio and keep the premiums flowing in.

      Alan

  7. Adrian July 30, 2014 3:10 am #

    Alan, I have actually have had to go to the Etf’s page for first time since I started papertrades and found 2 Etf’s to use too. My other option would be to go for higher priced stocks, although I wouldn’t be too fond of unless quite necessary.

    – Qu:- As you probably now know of my time difference from the US I have wondered whether now I am papertrading if it should only be done during the market hours, or could I keep putting on practice trades after-hours as I have been doing?(I usually use marketwatch.com for seeing the options value in the day)?
    What would you think of this now? Thanks

  8. Alan Ellman July 30, 2014 6:05 pm #

    Premium members:

    This week’s 8-page report of top-performing ETFs and analysis of ALL Select Sector Components has been uploaded to your premium site. The report also lists Top-performing ETFs with Weekly options as well as the implied volatility of all eligible candidates.

    For your convenience, here is the link to login to the premium site:

    http://www.thebluecollarinvestor.com/member/login.php

    NOT A PREMIUM MEMBER? Check out this link:

    http://www.thebluecollarinvestor.com/membership.shtml

    Alan and the BCI team

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