Trade Idea: A Narrow Calendar in a High Volatility Market

This market has been crazy for a couple of months now and this means that traders need to adapt to the conditions. I believe good traders can trade in almost any environment. A big part of my options journey is to learn how to trade in as many different market environments as possible. Only then can I consistently make money no matter what the market does.

As one who has only been trading consistently for about 5 years now this is, by far, the longest stretch I’ve ever seen with high market volatility. As many of you know I primarily trade SPX and my trading plans were built around normal volatility ranges with the VIX in the range of about 10-25. This market hasn’t been in this range since the start of the virus crash which is now been about 3 months. When it started, I did some of my usual alternative trades: trades on non-correlated things like metals, even doing some directional plays like synthetic covered call like I discussed in my last blog post. But this market is now in very new territory for me. VIX has settled down in the mid to upper 20s which is pretty low for the last 3 months but is still historically high. So what’s an SPX trader like myself to do? I usually don’t start going negative Vega trades like Butterflies until VIX is in the low 20s and forget calendars with their high positive Vega, right? Well…maybe not.

At least for now, a relatively low VIX is in the 20s. But that’s still pretty high. Calendars are tempting because volatility is relatively low compared to the last couple of months but it’s still high enough that calendars give you lots of room. But nothing is free in this market. The reason the market gives me a ton of room on calendars is because while a 25 VIX may feel low right now, it’s still quite high and so the risk of a big move is still around. Add in the fact that volatility is mean reverting and we could have the risk of dropping volatility while we’re very long Vega. That wide tent could contract and put the trade into trouble quicker. As I’ve stated in a previous blog post, when I set up my usual calendar in a low volatility market, I like to put my longs 2 weeks away from my shorts. This give me a nice mix of price and Vega exposure. The further out in time, the more expensive the calendar and the more Vega you get. This is because the longs will have more extrinsic value than the shorts so they will cost more and that extrinsic value will decay faster as the distance between them increases so you get more of a time difference and positive volatility exposure.

So how could a calendar be adapted to fit the market today? Here’s a modified setup that has been working well for more recently. I’ve named it a “narrow calendar” and it has the following differences from my standard calendar:

  • It is shorter in duration
  • The longs are very close to the shorts

To show some examples I need to set some guidelines. I could simply compare two calendars: one with 14 days between the shorts and the longs and one with three days. You will see a huge difference in the Greeks but I’m not this is a fair comparison because the risk is so much smaller. As you can see below:

An 11-day calendar with the longs 2 weeks out

This is an 11-day calendar with the longs 2 weeks from the shorts. The cost is $2291.30, I get very flat delta since it’s at the money and my Theta is 65 and my Vega is 106. Compare that with a one lot where I put the longs 3 days away and I get this:

An 11-day Calendar with the longs 3 days out

So you can see here, I have drastically less Theta and Vega but the cost is about 20% lower since the long is so much cheaper. This can be a benefit if you want to keep you risk down, but it’s not really a fair comparison with respect to the Greeks since they are proportional to size. So I think a fairer comparison is to make the narrow calendar a 5-lot to get similar risk size:

An 11-day Calendar with longs 3-days out (5-lot)

Now with a 5-lot the cost is $2306.50 which isn’t exactly the same but close enough that I think it’s a fairer comparison. The Vega is higher, but if you look at the ratio of Theta to Vega: it’s much better, almost 1:1. Yes, I have a bit more overall Vega risk but the Theta benefit more than makes up for it so my risk/reward ratio is better. And because this is a 5-lot, I’m able to scale this down to lower my risk while the first example is a 1-lot which can’t be scaled down.

So why wouldn’t I always do this style of calendar? The reason there is the volatility level of the market. I usually do calendars when VIX is under 13.5. In that environment, I don’t mind taking on more Vega risk relative to Theta because VIX is low and will most likely pop. But with VIX in the 25-30 range, I like to lower that ratio to help cushion the blow of a volatility drop. Also, when VIX is very low, I expect the size of the tent will be much narrower which will make this structure less appealing than it is now. So I would prefer to get more room by going back to a two week time spread.

Another thing to consider: with most underlyings you may only have Friday expirations so the shortest time you would have is one week. This is why I like doing this in SPX (or if you want to scale it down even more, you can use SPY), because it has Monday and Wednesday expirations so it’s possible to get very short distances between the shorts and the long.

Of course, I cannot say if this trade is right for you or not. Everyone’s experience level is different. If you aren’t familiar with spreads or calendars, you may want to paper trade a few to get the idea. Also feel free to check out my Options Fundamentals series where I try to explain these concepts in more detail for beginners. But it’s a good lesson in the Greeks and hopefully can spark some thinking about how to adapt a trade to different market conditions. If you would like to see how these trades have worked out, check out my This Week @MidwayTrades series around the end of May into early June. You can see my put these on and how I manage them.

As usual, I’d love to hear any feedback or questions on this or about options trading in general. Feel free to reach out here on the site or you can email me at midway@midwaytrades.com.

Midway Mail: Questions on My Calendar Setup

I always say I enjoy getting questions and fostering discussions and while I have been getting some very good feedback, I have found some questions that I think can be better answered in this forum than in email. I will keep the viewer anonymous, of course, but I think many traders out there could benefit from my answers and even come up with other (better?) ideas as well. I’m here to learn just as much as anyone so maybe someone out there has some better ideas and I’ll change my mind. All good stuff.

The viewer has some questions around the calendars I put on over the last few months. If you aren’t familiar with Calendars, check out Episode 13 my Options Fundamentals series. It should give you the basics of the trade and how it works.

Question 1: Why do my calendars more often than not start on the call side?

This is a great question and there isn’t one correct answer for everyone with respect to which side to use when setting up a calendar. When considering this, the first thing to determine is why you want to put a calendar on in the first place. This seems obvious, but I’ve seen lots of new traders put on trades without knowing why. There are traders who put on calendars to get a cheaper long call or put. They really want to be long a call or put but want to sell something against it to help pay for it. In this scenario, the ideal situation would be for the short to expire worthless leaving them with just a long call/put at a cheaper price since they got to keep the premium from the short option. In this case, it really matters which long option you want to have if the trade is successful. You really want to be directional, so you would choose the direction you want by choosing calls or puts.

However, that is not why I put on calendars. I am not a directional trader (outside of a rare speculation play) so for me, calls or puts isn’t nearly as important for my calendars. The reason I put on a calendar is that it is positive Theta and Vega and there times when I want those factors working in my favor. I almost always like Theta to be positive as I prefer time to work in my favor, but if the volatility of the underlying is low, I would rather be long volatility when trading it. I believe fundamentally that volatility is mean reverting, meaning that it always returns to the average. So when the volatility of my underlying is low, I would rather be long volatility since I believe it will go up. Conversely, when volatility is high, I like to be short volatility (negative Vega) since I believe it will go down. Of course, I cannot know how long it will take for this to happen, but the idea is to set up my trade to have the best chance to be helped by volatility. Since I also have time working in my favor, I can profit from that even if I don’t get the volatility move I expect, it just may take longer to get to my target profit.

Now that I’ve explained my goals of a calendar, I’ll try to (finally) answer the question. The answer is that, for me, it doesn’t really matter whether I start my standard at the money calendar in calls or puts. I intend to take it off as a spread so I’m not worried about which long I will have left. So how do I choose? I look at the open interest of the calls and puts that I intend to use and I pick the side that has the larger overall open interest.

So what is open interest? It’s a count of how many open positions exist on that particular option. It doesn’t matter if that open position is long or short so long as it’s open. This statistic gives us an idea of the liquidity of that particular option. The more open positions, the more interest there is in that particular option, the better the chance of getting good fill price with little to no slippage. Again, there are no guarantees here, but the idea is to put on a trade with as many factors in its favor to succeed. So if I have time on my side, potentially volatility on my side, and good liquidity so I’m not paying up for the position, I should have a better chance of success. Of course, price risk is always there as a calendar has risk on both sides as it’s a range-bound trade. But as I always say, this market pays me to take risk so there will always be risk somewhere.

So why did I end up choosing calls to start my position more often? Because during that time, the market was trending up which made calls more popular than puts. There could very easily be other times in the market when puts are more popular. So the preference for calls simply resulted from more open position in calls most likely caused by an upward moving market.

Let’s take a quick example. Let’s say I wanted to put on a calendar in SPX right now (note: I would not do that as volatility is too high, but this is just an example). I’ll do my usual shorts about 24 days out and my longs 14 days later (more on that later). Let’s look at the open Interest of each of my options:

Open Interest on shorts of a potential calendar

So, let’s assume I want to set up a calendar at the 3300 strike. So I choose 24 days for my short, and compare the open interest in the calls and puts. As you can see, the calls have a large advantage. But let’s also look at the options 14 days later.

Open Interest on the longs of potential calendar

So, in this case, the puts have a slight advantage over the calls. But it’s not enough to overcome the advantage of the shorts so I would start with calls here. It turns out today was a large up day so, again, it’s not surprising that the nearer term calls had such a large advantage.

None of this is to say that choosing the puts would be bad or wrong. Remember that using calls or puts doesn’t really matter to my calendar since I’m not worried about keeping the longs. And if I were to adjust the trade, I would most likely put on another set of calendars and I would use the puts for that to help keep my two calendars separate.

Question 2: Why are your calendars 2 weeks between the legs?

Another very good question and, again, there isn’t a perfect answer here. This has become a matter of preference for a couple of reasons. The first is this is the way I was originally taught to do the trade so there is some bias there. But, I keep doing it this way as I like the balance I get of risk and reward. All trades have risks and rewards and that ratio can be adjusted based on how the trade is entered.

As a quick reminder, a calendar is where I sell options and buy the same number of options at the same strike at some point later than the options I sold. It is this structure that gives the calendar it’s characteristics of being long Theta and long Vega. Why? A nearer term option has faster time decay than the same option further out in time. And in a calendar I am short the nearer term option so that is what gives me my time benefit (positive Theta). To get positive Vega, I buy my longs further out in time. Options further out in time have more volatility risk and since I am long the option that is further out in time, I get a positive Vega position.

So how does distance between the strikes affect the Greeks of the position? The further the distance in time between the legs, the greater the difference in the rate of time decay and so the result is more positive Theta. Similarly, the greater the distance in time between the legs, the greater the difference between the volatility risk and so the result is more positive Vega.

So why would I only choose 14 days? Surely, it would be better to increase the distance between the legs and get really high Theta and Vega working for me, right? Of course, there is no free lunch in this market and the price to be paid for having a large distance between the legs of a calendar is … price. In a calendar I am buying the further out option which has more extrinsic value (time and volatility) while being at same strike. This means that the greater the distance between the legs, the more the price of the longs will be compared to the shorts, which yields a higher debit for the trade which, in this trade, is my total risk. So I have to pay for the extra Theta and Vega with money from my account because the trade is more expensive. Let’s look at two examples:

A 24 day calendar with 1 week between legs

In this example, I have a simple calendar with the short 24 days out and the long 1 week later. This gives me 6.77 Theta and 46 Vega and will cost about $900. Now let’s push the long out to 6 weeks from the short:

A 24-day calendar with 6 weeks between legs

So this the exact same calendar but with the legs 6 weeks apart rather than 1 week apart. Here I get 32.84 in Theta, and 191 Vega which is much longer for both. But the cost of the trade is now $2726. So I have to spend about 3x more in capital to get the boost in Theta and Vega. That may look like a bargain, and there’s nothing wrong with taking that trade, but remember that Vega is a 2-way street. While it will be great if volatility goes up on this trade vs the 1-week trade however, if volatility goes down, I get hurt that much more as well. The other risk to consider is Gamma risk. While my deltas on these trades are similarly small, the Gamma is higher on the 2nd trade. While Gamma starts out small on both trades, the it will move Delta faster on the wider trade than the narrower one. This increases my price movement risk in a live market even though Delta starts off very neutral on both trades.

The Choices are Yours

I say all of this to say there is nothing bad about either trade as long as you, as the trader, understand the risks vs the rewards. There are many ways to set up a calendar to make these risk decisions. It’s up to the individual trader to decide what risks are worth taking versus the reward of the trade succeeding. A blog post is not the place to cover all of those possibilities but I did want to address the specific risks as it related to the questions asked. I hope this helped clarify what I’m doing as well as get you think about how to set up your trades.

Thank you again so much to the viewer who asked these questions. And I am very open to further questions or thoughts on anything on this site as well as trading in general. Feel free to follow-up here on the blog or reach out to me directly at midway@midwaytrades.com.

Until next time….. Good Trading!

Pets vs Cattle: My Biggest Trading Lesson

In the years I’ve been trading, I’ve learned many things. Of course, I started out with the mechanics of options, the Greeks, the strategies, etc. If you are interested in these fundamentals, check out my video series Options Fundamentals here on the the site or on my BitChute channel. I go over many of those early lessons about options trading.

But the craft of trading is more than just understanding the mechanics. Trading is also psychology. Paper trading is a useful tool, but you will never get the full experience until you are trading live money, your hard earned money. The ups and downs of the market become much more meaningful. It’s easy to get obsessed or stressed about your trades. The financial investment can lead to an even bigger emotional investment. Your idea is sound. Your plan will work. You have the skills to fix things when the market moves against you. You will make that profit. While confidence is certainly needed when one is in the risk management business (and that’s how I see options trading), you must be able to look at your trades as assets in your business. After all, what are options? They are simply contracts, a set of obligations that we exchange with others. They are derivatives of pieces of paper that represent ownership rights. Or in my case, as one who trades mainly the SPX, I trade a derivative of a derivative of pieces of paper which represent ownership rights

Why do I say all of this? Because recognizing this has helped lead me to the biggest lesson I’ve learned in trading so far. And the analogy I use is “Pets vs Cattle”. Bear with me for a bit and (I hope) it will all make sense.

If you have pets, as I do, you understand that they are more than just animal companions. To many of us, our pets are part of our family. We do our best to take care of them, feed them, get their shots, make sure they have the best life we can give them. When they get sick, we collectively spend billions of dollars a year getting them the best medical care we can. When they die, we mourn them. And, outside of truly obsessive behavior, all of that is perfectly fine and normal. We take in these animals, keep them in our homes and our lives and treat them and protect them as our own.

However…..

A farmer or rancher also has animals. He takes them in, feeds them, and protects them. But it’s very different. Those animals are not part of his family. His goal is to eventually sell these animals to make his living. If one of his animals gets sick, he is far less patient with medical care. Time and costs matter and he can’t let one sick cow infect the entire herd. While he may try some limited things to make that cow better, if that fails the cow must be put down and he moves on and focuses on the rest of the herd. To the rancher, the animals are a business asset. They exist to make him money to feed and protect his family (and his family’s pets). But he doesn’t have the emotional attachment to his cattle like he has with his pets.

So, let’s bring this back to trading. After learning the basics of trading, I struggled mightily with consistency. I knew how to win. But for ever few wins I’d get, one loss would wipe most, if not all, of those wins out. I just couldn’t get ahead and actually make any money that way. Losses happen in any business. You can’t avoid them. If you never lose, you never really took any risk and, as I said earlier, risk is how the options market pays traders.

So, I started critically reviewing my trades, especially the big losses. I needed to find what was common in my losses as well as what was common in my wins. And what I found was that when I would lose too much, most of the time I was holding onto a position too long trying to fix it and try make it profitable. I was adjusting my positions every time they went against me and was sticking with them stubbornly to try to make a bad trade work. In short, I was treating my trades like pets. I became emotionally attached to them. I knew if I just did more more adjustment, it would come back. This would go on until finally I was down so far that I finally gave up. A trade that I was trying to make a 10% profit was now down 35-40%. And when I tallied up my trades at the end of the month, it was those one or two bad losses that was the difference between a good month and a bad month.

I needed to change my attitude. I needed to see these trades for what they really were. My trades are my cattle. And like any herd of cattle, some won’t make it to market and that’s ultimately ok. But I can’t let one sick trade infect my account. Every trade takes up capital in my account. There are times when the best thing I can do is close the trade and re-deploy that capital into a new one that could be a winner.

So how am I applying this to the real world? First, before I put on a trade I always have a plan. That plan starts with the setup of the trade, the profit target, and the max loss. But the plan goes further. It also states what I will do when a trade moves against me. I have a plan for the upside as well as the downside. My plan then has the details for subsequent adjustments if needed. That’s all well and good, but I needed something more because just doing that wasn’t helping me avoid these bad losses. So I added some guidelines to my plan which I call my “Pets vs Cattle” rules to remind me of why I made them.

Guideline #1: I don’t adjust in the first 3-4 days. What I found was that when my trade went against me early and I started adjusting, I rarely made it back and it would have been better had I just closed the trade instead of adjusting at all. My trading style relies on Theta (time decay). Because I sell more extrinsic value than I buy, time works for me. But adjustments cost money, either by putting more cash or margin into the trade or taking a loss on part of the structure. So I’m sinking more capital into the trade to, essentially, buy more time for it to work. But if I do that very early in the trade, I haven’t really accumulated much time decay from which to draw. So I was digging myself into a deeper hole before realizing much Theta in the trade. And when I looked at the position at the first adjustment, it was usually a small loss or sometimes even a small gain or near break even. Here’s an example:

An example of a good loss.

So here I had my standard SPX 45-day butterfly. This shot was taken 3 days into the trade and I was already just outside of my butterfly tent. This is normally an adjustment point for me. But, instead I took the trade off for a loss of about $13 after expenses. On a $1300 trade, that’s about a 0.7% loss. Could I have adjusted here and saved it? Maybe. But if the trade goes against me this quickly, I’d rather just take it off and re-deploy the capital. Making up $13 on another trade is much easier than making up a max loss. This trade is cattle and I’d rather not sink more money into it if it’s not working early. Had this been day 5, I’d certainly consider adjusting, but not on day 3. (At 4 days, it’s a judgement call, thus the guidelines says 3-4 days).

Guideline #2: I consider taking off a trade that is at an adjustment point and up money. So assuming I’m past at or past the 4 day mark, if I’m at an adjustment point and up money, I could adjust it and try for more. But, more often than not, I’ll just take it off and re-deploy the capital. If the market gives you a profit, there’s nothing wrong with taking it. Generally if I’m up at least 4%, it’s a no-brainer to take it off. Less than that is when I’d consider adjusting since I’m getting close to break even.

Guideline #3. I limit the number of adjustments to around 4-5. Another observation I noticed in my bad losses was I was over-adjusting. This is somewhat related to the guideline #1 as adjusting too early can lead to over-adjusting. But as each adjustment costs money at some point I have to stop digging and move on. If I hit this limit, I take off the trade even if I’m not yet at my max loss. If I’ve adjusted 4-5 times in a trade, that’s a sign that the market conditions aren’t good for that particular trade and it’s best to take it off and either wait for things to calm down or put on a trade that is more conducive to the current market.

Ok, this blog would not be complete without an example of not following these rules so here it goes. On this trade back in 2018 (before I established my guidelines), I was doing an Iron Butterfly. My first adjustment came in day 2. I then went on to make 8 adjustments before taking a bad loss. Here is what the trade looked like on day 2 when I made my first adjustment

Bad Loss – Day 2

So, at this point, this trade isn’t in good shape. I’ve been in it for 2 days and I’m at an adjustment point and I’m $324 down or 11.5% on the trade. But I can fix it, right? I have an adjustment plan that will make this all better. Well, here’s what it looked like when I finally took it off after 7 more adjustments on day 15.

Bad loss after 8 adjustments in 15 days!

Ugh! I finally closed it for a loss of $1,145 or about 40%! So as bad as it may have felt to have lost $324 after 2 days. I’d take that over losing $820 more. But I was treating this trade like a pet, not cattle. Had I just cut my losses on day 2, I would have lost $324 but I could have re-deployed that capital and perhaps even made some or all of it back in the next 2 weeks. And it’s certainly easier to make up $325 than $1150.

So, hopefully, I’ve shown why a silly mantra of “Pets vs. Cattle” helped make me a better trader. I still say this to myself today whenever I’m tempted to break one of my guidelines. I put it in my trade notes when I close a trade early. This little phrase helps keep me from getting too attached to my trades. It reminds me to not get emotionally invested in my trades. Losses will happen and are ok as long as they are small losses. Maybe this can help you too.

As always, feel free to leave me feedback here on the site or reach out via email at midway@midwaytrades.com.

Good Trading!

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!