Index versus equity options
Lesson 4 · about 9 min
The rules you learned for stock options mostly carry over to index options, but the places where they differ are exactly the places that surprise people at settlement. This lesson lays out the differences side by side.
The comparison
| Feature | Equity / ETF option (e.g. on a stock or SPY) | Cash-settled index option (e.g. SPX, NDX, RUT) |
|---|---|---|
| Exercise style | American | European |
| Settlement | Physical delivery of 100 shares | Cash: the difference between strike and settlement value |
| Early assignment | Possible | Impossible |
| Multiplier | 100 | 100 (SPX is roughly 10× the size of SPY) |
| Last trading time | 4:00 pm ET (some ETFs 4:15 pm) | Varies: AM-settled monthlies stop the day before; PM-settled stop at 4:15 pm |
| Dividends | Affect pricing and early exercise | Not applicable (index has no dividend to capture) |
| US tax treatment | Ordinary short-term rules for most | Section 1256: 60% long-term / 40% short-term regardless of holding period, marked to market at year end |
Cash settlement worked through
You buy one SPX 5,000 call for $30 (that is $3,000) and hold it to expiration. The settlement value comes in at 5,045.
- Intrinsic value at settlement: 5,045 − 5,000 = 45 points.
- Cash received: 45 × $100 = $4,500.
- Profit: $4,500 − $3,000 = $1,500.
No shares change hands. Nothing appears in your account on Monday except cash. Compare a SPY 500 call held to the same expiration with SPY at 504.50: you would own 100 shares of SPY bought at $500, and you would need $50,000 in buying power to hold them or you would be forced to sell.
For sellers, cash settlement is the reason index options are popular for spreads: a short SPX put that expires in the money debits your account by the intrinsic value and is finished. A short SPY put that expires in the money leaves you long 100 shares over the weekend.
AM versus PM settlement
This is the trap. Standard third-Friday SPX options (and a few other index monthlies) are AM-settled: they stop trading at the close on Thursday, and the settlement value (often called SET) is computed from the opening prices of each index component on Friday morning. The Friday open can be a long way from the Thursday close, and you cannot trade the option in between.
Weekly and most other SPX expirations are PM-settled: they trade until 4:15 pm ET on the expiration day and settle on the closing index value.
A worked case. You hold a short SPX 5,000 put, AM-settled, expiring Friday. Thursday close: SPX 5,012, the put looks safe and you decide to let it expire. Overnight the futures drop 1%. The Friday opening prints for the components produce a SET of 4,962. You are debited (5,000 − 4,962) × $100 = $3,800 on a position you thought was dead. With a PM-settled contract you could have closed it Friday morning for a fraction of that.
Always check whether the contract you are trading is AM or PM settled. The exchange's expiration calendar lists it.
Which to use
Index options are the right tool when you want exposure to the broad market without the mechanics of stock: no early assignment, no dividends to think about, cash at the end, and (for US taxpayers) 1256 treatment. They are large: one SPX contract has the notional value of about $500,000 at an index level of 5,000. Smaller versions (XSP at one-tenth the size, and the ETF options on SPY, QQQ and IWM) exist for smaller accounts, at the cost of American exercise and physical delivery in the ETF case.
Equity options are for single-name views and for strategies that need the stock, such as covered calls and the wheel.
Key idea: Index options settle in cash, cannot be assigned early, and get 1256 tax treatment. The price of those advantages is size, and an AM-settlement rule on monthlies that can move the goalposts overnight.
A note on the tax line
The 60/40 rule under Section 1256 applies to broad-based index options in the US. It does not apply to options on ETFs like SPY, which are taxed as ordinary equity options. Tax rules change and depend on your situation; treat this as a pointer to check with a professional, not as advice.
Try it: Take an index level, say 5,000, and a strike, say 4,950 put. Compute the cash settlement for settlement values of 4,900, 4,950 and 5,000, for both the buyer and the seller. Then do the same for the equivalent ETF option at one-tenth the size and describe what the buyer's and seller's accounts actually contain on Monday.
Recap
- Equity and ETF options are American-style and settle in shares; index options are European-style and settle in cash.
- Cash settlement pays intrinsic value times the multiplier and leaves no stock position behind.
- AM-settled monthlies stop trading the day before expiration and settle on the next morning's opening prints; the gap between those two points is a real risk.
- Index options are large; smaller equivalents exist but carry the equity-option rules.
- Broad-based index options get Section 1256 tax treatment in the US; ETF options do not.
See it drawn
Original diagrams for the ideas on this page. Illustrative, not real market data.