Trekking Through Exchange-Traded Fund Options and Index Plays

Exchange-traded funds, or ETFs, and unit trusts tracking major market indices have become popular investments for individual investors who'd rather buy a basket of stocks than try to pick individual winners in today's tricky market.

Because most of these ETFs and unit trusts have options attached to them, investors have even more alternatives. That's why this week's Options Forum, on behalf of some readers needing a little direction, tackles the differences between indexoptions and options on tracking stocks and exchange-traded funds.

In your Nov. 16 article, you referenced a money manager who is hedging by buying puts on the QQQ (Nasdaq 100 unit trust (QQQ)). This got me curious.

Could you describe in a future article the pros and cons of buying options on ETFs vs. simply buying index options?

Clifford Hirschman

Clifford,

One of the primary differences between the two is the way they are exercised. For example, QQQ options are American-style exercise, meaning the options holder can exercise at any time prior to the options' expiration. The NDX options are European exercise and can only be exercised on the business day prior to expiration.

The bigger difference to you -- or most individual investors -- is the cost. Generally speaking, index options will be more expensive, given that such options provide leverage on a larger-valued index. For example, with the QQQ at 70, an at-the-money put provides the holder/exerciser the right to deliver 100 QQQs for $7,000. The NDX -- the index on which Nasdaq 100 options are based -- would be approximately 2800 at the same time the QQQ was at 70.

Thus, an at-the-money NDX 2800 would provide the option holder with the right to leverage of $280,000. (The QQQ is approximately 1/40th of the NDX. One would need to purchase more QQQ options to provide the same leverage.)

The QQQ options, which trade solely on the American Stock Exchange are index shares, and are physically settled with QQQ units or shares while an index option such as the NDX is cash settled, meaning there's no fungible underlying asset.

The underlying QQQ is described as such on the Amex Web site, and the NDX description may be found on the Chicago Board Options Exchange Web site.

Also important to remember when contrasting an ETF and an index option is that an ETF is more sensitive to demand in the market for the actual units, while an index option is a result of the component's movement.

As a result, the percentage move in the underlying QQQ, for example, frequently will be different from that of the NDX and the MNX, the CBOE Mini-NDX index. One of the reasons for this is that NDX and MNX options are based directly on the underlying Nasdaq 100 index, while the underlying QQQ trades on supply and demand in the market, like a stock. The QQQ, however, does closely track the NDX overall. As of Wednesday's close, the NDX was down 23.1% year-to-date, while the QQQ was down 22.6%.

And thanks, as usual, to the fine folks at the Options Industry Council's 1-888-OPTIONS Call Center for their assistance in answering these questions.

And remember, we're always open to reader questions, so drop a note to Options Forum and include your full name.

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