CBOE Special Feature: SPXPM vs. SPY Options

This complimentary article from Options Profits was originally published on February 8 at 8:18am EST. Don't risk missing over 40 options trade ideas every week and exclusive commentary from over 10 experts. Click here for more information and a 14-Day Free Trial.

Russell Rhoads is an instructor with The Options Institute at the Chicago Board Options Exchange. He is a financial author and editor having contributed to multiple magazines and edited several books for Wiley publishing. In 2008 he wrote Candlestick Charting For Dummies and is the author of Option Spread Trading: A Comprehensive Guide to Strategies and Tactics. Russell also wrote Trading VIX Derivatives: Trading and Hedging Strategies using VIX Futures, Options and Exchange-Traded Notes. In addition to his duties for the CBOE, he instructs a graduate level options course at the University of Illinois - Chicago and acts as an instructor for the Options Industry Council.

Russell: In October of 2011, CBOE's all electronic C2 Options Exchange began trading in index options based on the S&P 500®. The Chicago Board Options Exchange(CBOE) has been the venue for trading SPX options since the early 1980s, but those options are traded in an open outcry format. The new S&P 500-related options trade under the symbol SPXPM and are PM settled. PM settlement means the contracts will be settled based on the closing price of the S&P 500 at expiration. This differs from the process for SPX options which is AM settled.

SPXPM options are a viable alternative for those that actively trade options on the SPDR® S&P 500 exchange-traded fund(SPY). This exchange traded fund is most commonly referred to by its ticker SPY. A comparison of options on SPXPM versus options on the SPY appears in the table below:

The underlying instrument value in the table is based on the S&P 500 at a level of 1300 and the SPY priced at 130. Usually the SPY is very close to 1/10th the price of the S&P 500 index so a 10-to-1 ratio of SPY to SPXPM options would be a good comparison. Both SPXPM and SPY options are PM settled based on the respective closing prices of the S&P 500 and SPY. SPXPM option contracts are European style which means they may only be exercised at expiration. This is not true with SPY option contracts. Options on the SPY are American style, like all equity options that trade in the United States, which means there is always the possibility of early assignment if a short position is held in an SPY option. Upon settlement SPXPM option contracts will result in receiving or paying cash if an option is in the money at expiration. Settlement for SPY options results in a transaction in shares of the SPY exchange traded fund Finally, at CBOE, SPY options trade in a hybrid format where open outcry or electronic trades may be executed. SPXPM options are 100% electronic. Both are traded with slightly different market models, but both may be executed with the click of a mouse.

Trading Example:

If you were bullish going into the first three weeks of 2012, you would have been right as the market was up over 4%. One of the ways you may have chosen to trade this outlook would be by purchasing call options that have an underlying that is tied to the direction of the overall stock market. Two choices may be SPY or SPXPM call options that expired on January 21, 2012. These are good comparable instruments as both are settled based on the closing prices of their respective markets on the third Friday of the month. Let's assume we execute our trades just before the market closed on the last day of 2011. The SPY closed at $125.50 and the SPX closed at 1257.60 on December 30 of last year. Based on these levels we decided to check out buying 10 SPY January 126 Calls at $2.22 each or purchasing 1 SPXPM 1260 call at $22.20.

Remember SPY options have very close to 1/10th the underlying value of an SPXPM option contract so to get the same dollar exposure as a single SPXPM call we need to buy 10 SPY options. The result of this may be higher commissions if you have to pay a per contract commission to execute the trade. This will vary from broker to broker so you should check directly with your broker to determine what the commission difference may be.

Let's fast forward to the close of the market on January 21. The trade worked out quite well as the SPY closed at $131.54 and the S&P 500 closed at 1315.38. Based on these prices the SPY January 126 call is $5.54 in-the-money and the SPXPM 1260 call is $55.38 in-the-money. Excluding commissions, buying 10 SPY January 126 calls would have resulted in a profit of $3,320 while buying 1 of the SPXPM 1260 call options would have resulted in a profit of $3,318. However, there are differences when you look at how you go about pocketing this profit.

Through a long position in 10 SPY January 126 Calls you have the right to buy 1,000 shares of SPY at $126.00. If you have $12,600 to invest and are long-term bullish on the market then you may choose to go through the exercise process. However, the intent of this trade was to profit from a short-term price move. The S&P 500 moved higher over the three weeks between December 30 and January 21 and SPY call options moved up in value. If your intent was a short-term profit then you would need to exit your option position by selling your 10 SPY January 126 calls in the open market. The process for taking cash profits in an SPXPM option contract is a little different. Index options are cash settled instruments. In the case of owning 1 SPXPM 1260 call, you can just hold the contract through expiration and the result is a cash payment of the intrinsic value of the option. No trading action is necessary.

Another big difference is the potential tax implication of these trades. According to Taxes and Investing -- A Guide for the Individual Investor, SPXPM options are considered "Section 1256 contracts" which results in two distinct characteristics. 1256 contracts are treated as sold ("marked to market") on the last day of the year. Gain or loss resulting from such marking to market is treated as 60% long term capital gain or loss and 40% short-term capital gain or loss. This is commonly referred to as 60/40 tax treatment. With respect to the SPY option position, the taxation of options on exchange traded fund shares where the underlying portfolio or index is broad based is currently uncertain and requires guidance from the IRS.

So if you have a stock market outlook and are thinking of putting on an SPY option trade you may want to check out SPXPM options as an alternative. SPXPM options may be executed with the click of a mouse just like SPY options. A single SPXPM option should give you about ten times the market exposure as a comparable SPY option contract. Also, if the goal is to hold an option through expiration, the cash settlement process may be easier than executing a sell order in SPY options. Finally, depending on your personal situation, there may be a tax benefit to trading SPXPM options versus SPY options.

Additional resources to compliment the article:

http://www.cboe.com/micro/spxpm/default.aspx

cfe.cboe.com

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Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options. Copies are available from your broker, by calling 1-888-OPTIONS, or from The Options Clearing Corporation at www.theocc.com. Commissions, fees, margin interest and taxes have not been included in the examples used in this article. These costs will impact the outcome of all transactions and must be considered prior to entering into any transactions. Investors should consult with their tax advisors to determine how the profit and loss on any particular option strategy will be taxed. Tax laws and regulations change from time to time and may be subject to varying interpretations. CBOE® and Chicago Board Options Exchange® are registered trademarks and SPX is a service mark of CBOE. C2, C2 Options Exchange and SPXpm are service marks of C2 Options Exchange, Incorporated (C2). S&P® and S&P 500® are trademarks of Standard & Poor's Financial Services, LLC and have been licensed for use by CBOE and C2. SPXpm is not sponsored, endorsed, sold or promoted by Standard & Poor's, and Standard & Poor's makes no representation regarding the advisability of investing in SPXpm. Copyright © 2012 Chicago Board Options Exchange, Incorporated. All rights reserved.

At the time of publication, Russell Rhoads held no positions in the stocks or issues mentioned.