Why I Primarily Trade SPX

Those out there who follow my trades, especially my weekly series This Week @MidwayTrades will notice that I primarily trade one underlying vehicle: options on SPX, the S&P 500 Index. I occasionally do small spec trades in other underlyings but anything I do regularly and of significant size is always in SPX. This is not the way a lot of retail options traders operate so I thought it would be worth a blog post to explain why I spend so much time trading options of one underlying. Let me say up front, none of this is to say that there is anything wrong with playing lots of different options. I always say if you can consistently make money trading a different way, that’s the right way for you to trade. But in this post, I will spell out why I prefer to trade SPX whenever market conditions allow it (which is most of the time).

1. Liquidity

To me, liquidity is essential. Without liquidity, do you really know the worth of your position? I would argue no. Market prices are set when buyers and sellers agree on a price and if no one else is participating in a market, it’s tough to tell the actual price of something in that market. The CBOE (Chicago Board Options Exchange) tracks activity of nearly 3000 underlyings that trade options. I personally would only be interested in trading options in the top 100 in terms of volume. You can find this list here for your own inspection. This is for equities. I found stats on indices here. You will find that SPX is not only well in the top 100, but top 10-15 depending on the time frame. With all the available options out there to trade, why spend time and money fighting to get a fill on a low volume/open interest contract? Price slippage is very real and I rarely, if ever, have to give in more than $.10 of a reasonable mid-price for SPX, usually less.

Outside of good fills, good liquidity also gives far more options to trade (i.e. more strikes, and more expirations). SPX not only has Friday weekly expiration but Monday and Wednesday as well. I used to avoid the non-Friday expirations, but recently I’ve found that I get good fills on Wednesday as well. This makes it easier to put on multiple positions in a single account without stepping on other trades in the same expiration which can lead to confusion when closing or adjusting trades.

2. High Prices

I see lots of traders who head to the bargain basement because the option prices are cheap. It’s certainly tempting just as it is trading stocks. But there’s a downside to this. In stocks, it’s usually that the stock has a low price for a reason (low quality). But for options it means there isn’t much in the way of premium. As a trader who likes to sell premium, this means I have to trade a lot more contracts to generate enough premium to make it worth the risk. And while commission costs have come down significantly even this very year, they still add up vs the amount I want to make selling premium. A quick side note: when I say I sell premium that doesn’t mean just selling options or even that I open a trade for a net credit. In my non-spec trades, I am always selling more time premium than I am buying (thus being positive theta) and in many cases I am also selling more volatility than I am buying (unless volatility is extremely low as it is right now in which case I set up my trades to be positive vega and I’m a volatility buyer). But the price of the option starts with the price of the underlying. At the time of this post, SPX is a $3100 index. That means that even trading a one lot can involve over $1000 in margin. As I’m trying to make 7-10% of that as a successful trade, this means I can trade fewer contracts to make a decent amount of money on a trade. This is one of the reasons I prefer SPX to the ETF for the S&P 500 SPY which is priced at about 10% of SPX. Yes, the prices are lower, but I would need to trade 10 contracts for every 1 of SPX and that is 10X the commission to my broker. There are other reasons I prefer SPX to SPY that will come later. But the bottom line is, outside of unusual small spec plays, I prefer to trade underlyings above $80/share. Below that it’s tough to get enough premium to sell to make a decent profit.

3. Diversification

A nice feature of a large index like SPX is that it represents many different companies across different sectors by design. The S&P 500 consists of (to no one’s surprise) 500 stocks. That means that by trading this underlying I get a certain amount of sector diversification built-in. Is it perfect? Of course not. The index can get out of balance at times. But it’s rarely so out of whack that one stock or one sector will destroy it. I still have to be aware of what’s going on and be ready to take action if something does happen to move the index but it’s less impactful than say, earnings or news on one stock which can move it several standard deviations in a day.

And that’s another advantage: SPX doesn’t have earnings events in the same way that individual stocks do. Individual components have them all the time but they are spread out over many days so the effect is muted. That isn’t to say that there are no events that cause a move. The biggest one these days is Fed announcements. I do keep track of Fed meetings and am a bit cautious adding new positions right on top of them. There’s a nice site that keeps track of economic news on a daily and weekly basis called Econoday and it’s not a bad idea to keep a browser tab open to it on your trading station. Other news can move the index as well, the recent trade war has certainly moved the market and has been unpredictable at times, but I have found the risk to be more manageable than individual stocks.

4. Cash Settlemement

Equity options are generally settled in shares of the stock. Options that expire in the money are usually automatically assigned and shares of stocks change hands as a result. But indicies like SPX do not have actual shares so their options are cash settled. This is another difference between options directly on the index and ETFs (like SPY) based on an index. SPY options are settled in shares of SPY.

Now, it’s reasonable to think that as long as I close my position before expiration, this isn’t really an issue. Except that with share settled options, there is always a risk of early exercise. The buyer of the option, most of the time has the right to exercise their right at any time during the life of the contract (this is known as American style). But since there are no actual shares to exercise, options on indicies do not have early assignment (this is known as European style). I will use SPY as an example since it is an ETF based on the S&P 500. SPY has a dividend based on the dividends of the stocks in the index. One of the reasons that options get exercised early is to capture a dividend. Another can be a buyout. This happened to me once in my early trading days. I was writing covered calls against a position and the company got bought out for a higher price than the strike price on the calls I was writing. The next day, my shares were called away. The SPX doesn’t have real shares and, therefore, has no dividend and, while buyouts can happen to companies in the index, the index itself can’t be bought out so there’s no real advantage to early exercise which is why it’s European style.

5. Tax Treatment

This is US specific so if you are not in the US it may not apply to you. But in the US we have capital gains taxes as part of our income tax system. The basic idea is that selling something for a profit generates income that falls under our income tax. But the US tax code distinguishes long-term capital gains (meaning you held something for at least a year) and short-term capital gains. Most options are held for under a year unless you are dealing exclusively in LEAPs so any profits made by them would be taxed at the short term rate (which is my regular income tax rate vs the long term rate of 15%). But options on “broad-based indicies” (which includes SPX) are treated differently. Any profit I make on SPX options where I held it for less than a year (which is all of them in my case) is taxed 60% at the long term rate and 40% at the short term rate. While this is not a huge advantage for me, it’s a nice bonus. This tax treatment does not apply, however, to ETFs like SPY. Of the 5 points made here, this is the least important, but I thought it is still worth mentioning as a reason to trade options in big idicies.

Conclusion

There are multiple ways to make money in options. My style is mostly around non-directional plays on big indicies. SPX isn’t the only big index out there with options. I have traded options in the Russell 2000 (RUT) which is based on smaller companies than SPX. It tends to be a bit more volatile, but it is quite trade-able and all of these points would apply. As is the NASDAQ index which is priced even higher than SPX. But at the end of the day, each trader needs to find out what works for that particular person. There’s no one right way to trade. But I thought this discussion of SPX may, in addition to helping some folks learn more about options, could lead to other discussions of trading ideas. Feel free to comment below or reach out to me privately at midway@midwaytrades.com.

Good Trading!

Pro Tips: Trading on the Road

Anyone who has followed me here or on other social media sites knows that I am a part-time trader with a day job. On the upside, my day job allows me to work from home much of the time so monitoring trades is certainly easier than being at an office. On the downside, I travel quite a bit. I’m generally on a plane somewhere about twice a month. Sometimes simple day trips, other times across the ocean. So I’ve had to adapt my trading style to allow me to keep trading while I’m on the road. Of course, you can limit how much you put on if you know you’re going to be away from things but I don’t always get a ton of notice on my trips and even if I don’t put anything new on, I may have existing trades that I’d rather not exit early. So this post is about the things I’ve learned over the past few years to trade on the road. I think it will help not only road warriors, but also people who have a life and don’t want to sit in front of a screen all day. Trading is great, but so is life so we traders should be able to handle life while the market is open.

Tip 1: Trade Longer Durations

Really short term trades (which I would define as expiring in 14 days or less) can be a lot of fun. I mean, who doesn’t like to make money quickly, right? But here’s the catch: as options get closer to expiration, delta and gamma can get really significant which means you need to be ready to respond to price movements very quickly if your underlying moves against your position. In my videos I’ve said many times how I like to avoid “Gamma Week” (i.e. the week of expiration) because the price movement risk generally isn’t worth the theta reward. Now compound this with travelling and being away from the screen and you can get into trouble quickly and your trade can blow up before you get a chance to do anything which can lead to bad losses. That’s why I tend to position my trades no less than about 21 days out and regularly go 45-60 days out for many of them. This helps keep my delta and gamma under control (in exchange for less theta at the start of the trade) and gives me more time to react. Does this protect me against all big, fast moves? No. There are no guarantees in this business, I get paid to take risk after all. But if I can’t do something for an hour or two, I have a much better chance to take action when my price risk is lower.

Tip 2: Set Alerts

When I’, away from my main trading station, I may not be in a position to check the market as much as I would normally. I’m probably away for a reason whether it’s driving, flying, a client meeting, and constantly checking the market isn’t always possible or even the right thing to do. So before I head out (sometimes even the night before), I take some time to examine my positions and find the price levels where I would want to take action. Of course, I will always have a closing order at my broker to take off my position if it hits my target, but I want to be alerted if my underlying hits a point where I would consider an adjustment. Any decent trading platform has a feature where it can send you an alert if certain market conditions are met. At a minimum, I can be alerted if an underlying hits or breaks certain price levels. Some platforms allow clients be alerted if certain options in their positions break certain greek level (e.g. the delta of option X goes higher than 8). So I decide those levels up-front and set alerts on my phone to buzz me we’re getting close to a point where I’d like to adjust. I can’t always act on it immediately, but it’s nice to know if it’s even an issue so I can figure out when to pay more attention to my positions and take some action. Which leads to….

Tip 3: Pre-stage Adjustments

When I’m away from my home office, it’s not always possible to fire up my laptop and make an adjustment. But building spreads on a phone app isn’t the easiest thing to do even with good platforms if, for no other reason, the screen real estate is limited. So along with my alert that a position may need attention, I will pre-stage an adjustment in my platform to make it easier to execute it on my phone. Since I always have a plan for each trade before I put it on, I know what I want to do if my underlying reaches a certain level. The simplest case is to close the position. In that case, since I already have an order at my broker to close, it’s simply a matter of changing my limit order (ALWAYS use limit orders), to a price that can be executed. However, in the case where I want to adjust, I will pre-stage my adjustment at my broker but set an unrealistic price so that it will never be executed. For example, let’s say my adjustment is to buy a spread, and let’s say that spread currently has a mid-price of $9. I will put in an order to buy the spread at $3. There is very little chance that spread price will ever be filled which is exactly what I want. So, as in the first case, I can simply change my limit order to a realistic price that can be filled at that time. That way it is possible to get my desired adjustment on even with the simplified interface of a phone app. And this is something that could be done during a “bathroom break” or some other similar moments that happen throughout the day.

Tip 4: Leveraging the Cloud

There are times when I can’t be near my trading station but it’s not circumstances make it tough to trade on the road. Ever tried to trade with flaky airplane internet? It’s not pretty. Another airplane problem is that you can’t use your laptop during takeoff and landing…but you can use a tablet. But, if you’ve watched my videos in addition to my trading platform I use a modeling software as well and the one I use only runs on Windows: not an ideal platform for my iPad. My solution for this is to leverage the cloud, namely, Amazon Web Services (aws.amazon.com). There are others out there and if you prefer them, that’s fine but the concept is the same. I have found that I can run a Windows machine in Amazon capable of sustaining my trading platform and modeling software for about $.032 an hour (yes, that’s 3.2 US cents an hour). Doing this gives me a couple of advantages.

First, I can run access this Windows machine from just about any platform by using MicroSoft’s Remote Desktop Protocol (RDP). Clients are available for just about everything out there including tablets, as well as non-Windows computers. This gives me a full Windows experience with all of the software tools I have at home (other than screen size) at a really affordable price since I only pay for the time I actually use it and I shut it down when I’m done for the day and I pay nothing while it’s shut down. So a big AWS bill for me for a month would be $6-7. It’s usually less.

But second and, perhaps, more importantly it helps with the low bandwidth/flaky internet problem because all of the connections to my broker are going over Amazon’s network which is pretty stable and fast. And the only traffic coming over the airplane internet is the stream of the screen and the keyboard/mouse inputs from my device which has very low demands in comparison. So by doing this, I’ve been able to not only adjust but to initiate new trades over the Atlantic on airplane internet on my iPad. This is very convenient and the price is quite reasonable. This may not be for everyone, but I think it may help some folks out there with similar issues. If you’re interested in how to set this up, I’ve included a link to a video below which I will also upload to my BitChute channel.

Download the Trading on the Road Video // Stream the video on BitChute

Anyway, I hope some of these tips help traders out there who, for whatever reason, can’t sit in front of a screen all day. If you have any questions/comments about this, please don’t hesitate to reach out. Or if you have other cool ideas, feel free to share them.

— Midway