Advantages of Trading Indexed Options

Diversification

Options based on indices rather than individual stocks provide investors with diversification.

In finance, a text book will tell you that diversification means the removal of unsystematic risk. However, if you've ever come across the saying "don't put all your eggs in one basket" then you have already been introduced to the concept of diversification. It basically means spreading your investment across multiple assets, in this case, multiple stocks with the objective of reducing (or evening out) your overall risk.

A stock index is a compilation of many stocks. The S&P 500 is meant to resemble a portfolio made up of 500 individual companies. Index options based off the S&P 500 (SPX) give option traders the chance to construct option strategies and techniques to bet on the entire market rather than the performance of one individual stock. The Russell 2000 is made up of 2000 small cap companies.

Predictability

I don't mean to infer that index options are easy to predict. But index options are generally less volatile than the component stocks that make up the index.

Earnings reports, takeover rumors, news and other market events are what drive volatility in individual stocks. An index tends to smooth out the wild ups and downs of the stock basket and hence options based off an index will also show lower fluctuations.

Liquidity

Index options are very popular for option traders, hedge funds and investment firms. This popularity drives up the volumes available to trade and reduces the spreads quoted in the market. This competition means that you will always have a fair price to trade at and plenty of volume too.

European Style Expiration

All standardized equity options use American-style exercise. American-style exercise means that operationally you can exercise your contract any day that the market is open before the expiration date. The last day to exercise an American-style option is usually the third Friday of the month in which the contract expires (expiration Friday). Most index options, however, use European-style exercise. This means that the only time you can operationally exercise your contract is the last trading day (usually Friday) before expiration. Remember, even though there is only one day in which you can exercise your contract, you can always close out your option position in the secondary market any day prior to expiration. This means that you have until expiry to adjust your trade without fear of an early assignment of the underlying security.

Tax Advantages

Section 1256 Contracts Marked to Market

Trading broad-based index options for taxable accounts can have some favorable consequences when paying federal income taxes. The IRS has a provision known as a Section 1256 Contracts Marked to Market. A section 1256 contract is any:

  1. Regulated futures contract,
  2. Foreign currency contract,
  3. Non-equity option,
  4. Dealer equity option, or
  5. Dealer securities futures contract.

Broad-based Index Options

The third item in this list, non-equity option, is of interest for trading index options. The IRS defines a non-equity option as "any listed option that is not an equity option." According to the IRS, non-stock options include debt options, commodity futures options, currency options, and broad-based stock index options. A broad-based stock index is based upon the value of a group of diversified stocks or securities (ten or more). Standard and Poor's 500 index is one example of a broad-based stock index.

60/40 Rule

Generally, capital gains from stock or stock option investments held less than one year are considered short-term and those held longer than one year are considered long-term. However, according to the IRS, under the marked to market system, 60% of a capital gain or loss may be treated as a long-term capital gain or loss and 40% may be treated as a short-term capital gain or loss, even if the position was held for less than a year. The ramification of this rule is that capital gains or losses considered to be long-term have lower marginal tax rates than short-term capital gains or losses, and index options on broad-based indexes qualifying under the 60/40 rule have a more favorable tax treatment over options on equities considered short-term investments.

Example

For example, for a short-term capital gain with a marginal tax rate of 35%, the marginal taxes on a $1,000 capital gain would be $350 and for a long-term capital gain with a marginal tax rate of 15%, the marginal taxes on $1,000 would be $150. Using the 60/40 rule, 60% of the capital gain, $600, would be taxed at 15% and 40% of the capital gain, $400, would be taxed at 35%, so the taxes paid under the 60/40 rule would be $90 for the portion considered long-term and $140 for the portion considered short-term for a total of $230 which is $120 less than if the total capital gain were considered short-term. The composite marginal tax rate for this example of the 60/40 rule is 23%, 12% less than the 35% rate for short-term capital gains and represents paying 34% less in income taxes.

Processing your request...

This may take a few moments...