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VIDEOOptions 101: Find Your Trading Strategy
Certain strategies work best with certain underlyings.
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As new traders delve into options, they inevitably discover that there are a variety of options strategies. What they may not understand is that many strategies work best with certain underlyings.
The 3 basic types of options are equity options, ETF options and index options. The last is the easiest to discuss. Index options are widely traded but have no single underlying. For instance, the S&P 500 (SPX) has options, but the underlying is the index of the 500 stocks. These options are widely traded, usually number 2 behind the S&P 500 exchange traded fund (SPY) options.
The SPX options are used primarily by large institutions looking for protection in the form of puts and/or covered calls (part of this is because of the high cost -- 1 SPX option could cost $10,000). This action has 2 significant influences: The first is known as the options skew or "smile." With most of the natural action being the sale of out-of-the-money calls and purchase of out-of-the-money puts, the implied volatility increases as the strike decreases.
The second outcome is that the implied volatility increases as the underlying stocks drop. As stocks fall, institutions are willing to pay more to insure their portfolios, driving up the cost of that insurance. That is why the VIX, which is the index of the implied volatility of those SPX options, is known as the "fear index" and moves inversely to the markets.
Finally, there are some fundamental differences. Index options are "cash settled," meaning that they settle in cash instead of the underlying shares. Most have a Friday-morning opening settlement, and almost all of them are "European-style" options, which can be exercised only on the day of expiration. Index options are also taxed differently, similar to futures contracts. (See optionMONSTER's Education section.)
ETF options are similar to index options, but there are some important differences. The first is that there's an underlying, and the options do settle in those shares. ETF contracts, like all equity options, are "American-style" options, which can be exercised anytime before expiration. There are a wide variety of ETF options - on everything from bonds and sectors to stocks in other countries.
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