With the broad markets near all-time highs, it’s understandable that many investors might consider trading index options. They can be a way to buy protection against a market decline, make a limited risk, short term, directional bet – on either further market declines or a fast rebound – or to sell options in an attempt to add income to a portfolio during quiet periods.

Let’s take a look at the market mechanics of the options that are available to trade.

The first successful index options product was the OEX – the Chicago Board Options Exchange (CBOE Quick QuoteCBOE - Research Report) options on the S&P 100 index. Introduced in 1983, they quickly became the preferred instrument for traders to transfer risk in a broad based, large cap equity index. Over time, the OEX options were surpassed in popularity by the SPX – options on the S&P 500. Public awareness of the 500 index, European-style exercise and the existence of a liquid S&P 500 futures contract traded at the Chicago Mercantile Exchange (CME)  that could be used as a hedge made the SPX a better choice for most traders. SPX became the highest volume and most liquid index options in the world.

One of the features that makes SPX attractive is that it is “cash settled” – meaning that when an option expires in the money and is exercised, the long and short sides to an option exchange the difference between the index settlement price and the strike price in cash rather than shares of stock. Because of the European-style exercise, options are only exercised at expiration. The owner of a long option is free to sell it in the market any time he likes, but unlike an option on a single stock, it cannot be exercised early.

(Note: It’s not actually the two counterparties to the original trade who make the transfer. The Options Clearing Corporation act as the center counterparty, collecting debits owed and distributing them to those owed credits – and ensuring through its margin system that all market participants are sufficiently well capitalized to cover their trading activity, eliminating the possibility of default.)

In the 1990s, the popularity of Exchange Traded Funds that track the movement of broad-market indexes and the subsequent listing of options on those ETFs gave traders and investors another way to gain exposure to the movement of the indexes.

To illustrate the difference that cash settlement makes, let’s look at options on the SPX as well as options on SPY, which is the ETF that tracks the S&P 500 and trades like an equity security.

The price of the SPY is basically 1/10 of the value of the cash S&P 500 index. A value of 3,900 for the S&P 500 would mean the SPY is trading around $390/share.

Because of the interest costs associated with holding an equity security as well as the fact that the SPY passes through dividends to investors, the price is not exactly 1/10, but it’s fairly close - and for the purposes of our examples, the difference is negligible.

If you were to purchase a 400 strike call on SPY that expires on March 19^th 2021 for $2.65, your account would be debited $265 in cash on the day you made the purchase. If at expiration, SPY was trading $415, the option would be automatically exercised and you would purchase 100 shares of SPY for $400/share. If you chose, you could immediately sell them for $415 and keep the $1,500 difference.

If you were to purchase the 4,000 strike call on the SPX for $26.50, your account would be debited $2,650 in cash on the day of the purchase, and if the price of the index was 4,150 at expiration, you would receive a cash credit of $15,000.

You can see that in terms of total profit and loss there’s very little difference between buying 10 of the SPY calls or 1 of the SPX calls.

So why would you choose one over the other?

You might chose SPY options if you are already familiar and comfortable with trading options on individual stocks and simply want a product that works exactly that same way. Also, if you were going to trade less than ten contracts or wanted the flexibility to close less than 10 contracts worth of your position at a time, SPY allows you to do that.

You might instead choose SPX if you want to avoid the possibility of taking delivery of shares of stock as a result of your trade. If you intend to hold a cash-settled option to expiration, you don’t need to do anything else. At expiration it’s either in the money and the transfer of cash happens automatically or it’s out of the money and expires worthless.

Though early exercise of SPY options is fairly rare, it is possible, whereas you can be certain that SPX options will never be exercised prior to expiration.

SPX options also offer a larger number of expiration cycles, including options that expire mid-week and options that expire in the morning after the last day of trading rather than the afternoon of the last day. If the strategy you are employing is based on the expected movement of the index around a particular event, the SPX might allow you to choose an expiration date and time that’s more closely tailored to your time frame.  (Because of the greater range of choices, it’s also important to pay close attention to the expiration you’re choosing before placing an order.  There are a lot of them.)

The cash-settled options may be a little intimidating if you’re not familiar with them, but they're actually easy to understand and may well suit your purposes better for some strategies.

Finally, there’s the standard “Know Your Options” caveat: Your brokerage firm may have different capital and/or margin requirements for trading cash-settled options than for equity options. If you’re in doubt, always contact them to make sure you understand their policies before making a trade.

David Borun runs the Zacks Marijuana Innovators Portfolio as well as the Black Box Trading Service and the Short Sell List Trading Service. Want to see more articles from this author? Scroll up to the top of this article and click the “+Follow” button to get an email each time a new article is published.

Interested in strategies with profit potential even in declining markets? Maybe our Short Sell List Trader service is for you.

Want to apply this winning option strategy and others to your trading? Then be sure to check out our Zacks Options Trader service.