Index Options

Index options are based on a stock index or another type of index rather than on specific stocks or on the specific underlying assets of the index. The value of index calls increases as the index increases, and the value of index puts increases as the underlying index decreases.

Index options have advantages over other options. Because these options are based on indexes, there is greater diversification, and usually less volatility than with stock options. An index will never drop to zero, and it will never increase as dramatically as some specific stocks can, especially within a short time. Therefore, the risk is more limited, but so is the profit potential. Also, contract adjustments are rarely needed for a stock index. For instance, stock splits of stocks within the index do not affect the index, and thus, no adjustments on the contracts are needed. Index options are settled in cash, so there is no need to transfer or take delivery of the underlying assets. Trading accounts are credited or debited in cash: no need to buy or sell securities.

The strike price is based on an index value multiplied by the contract multiplier, which is usually $100, but could be as little as $1, such as for nano options. These options are settled by the exchange of cash, not securities, which, for obvious reasons, is called a cash settlement. The option writer who is assigned an exercise pays cash to the holder who exercised the option.

Most index options are European-style options that can be exercised for a short time right before or after expiration, thereby eliminating the risk of early assignment. However, this makes little difference for options settled in cash, because the option can always be sold for cash at any time before expiration.

The cash that is paid upon exercise depends on the index, which depends on the component prices of the index. Some contracts have AM settlement and some have PM settlement. In AM settlement, the cash settlement value is calculated using the opening component prices on the day of expiration; the last trading day for these options is the day before. Since expiration dates usually fall on a Friday, the last trading day for AM-settled options is the previous business day, usually on Thursday. In PM settlement, closing prices on the day of expiration, usually a Friday, are used to determine the cash settlement value of the contract.

The cash settlement amount is determined by multiplying the absolute difference between the index and the strike price of the option times the contract multiplier, which for most S&P 500 options is $100.

Call Cash Settlement Amount = (Index Value − Strike Price) × Contract Multiplier

Put Cash Settlement Amount = (Strike Price − Index Value ) × Contract Multiplier

Examples of Index Option Settlement

SPX is the most popular index option on the S&P 500 index. On the exercise date of these options:

Case 1:

Case 2:

Extended Market Hours for Trading Popular Index Options

The most popular index options have extended trading hours. The S&P 500 Index (SPX) options, Cboe Volatility Index® (VIX) options and Mini-SPX Index (XSP) options from CBOE trade almost 24/5.

Daily trading hours range from 8:15 PM to 9:15 AM Eastern Time, with some breaks in the trading session:

The trading week for these options begins Sunday, 8:15 PM and ends Friday, 5PM.

Taxation: 60/40 Tax Treatment of Section 1256 Contracts

Most index options are so-called Section 1256 contracts, because they are non-equity options, which are given preferential tax treatment. Regardless of how long the contracts have been held:

Thus, the maximum tax rate of an index option is just 26.8%, or 30.6% if the 3.8% Net Investment Income Tax, which will apply to taxpayers at the highest marginal rate, is included.

Example: How Taxes on Gains and Losses Are Calculated Using the 60/40 Rule for Section 1256 Contracts

Marked-to-Market Rules

A drawback to Section 1256 contracts is that the tax must be paid every year even if the position is not sold by yearend. A gain or loss must be determined on all §1256 contracts held for speculative profits — but not for hedging — based on their fair market value (FMV) at the end of the tax year. These results will later be used to modify the actual gain or loss realized when the contracts are finally sold or closed.

Gains and losses from Section 1256 contracts are figured on Form 6781, Gains and Losses From Section 1256 Contracts and Straddles.

Types of Index Options

These are the major index options.

S&P 500 Index Options

Nasdaq Index Options

Nano Options

The Chicago Board Options Exchange (CBOE) has launched nano options on the S&P 500 Index in early 2022. These options are 1/100 of the size of the mini-S&P 500 options and 1/1000 the size of regular options, with a maximum maturity of 1 week and settled in cash.

Nano options are cheaper contracts with a multiplier of only 1. Most option contracts have a multiplier of 100, meaning that the price is 100 times greater than the listed price. So, an option with the listed price of $1 would actually cost $100 but a nano option with the same listed price would cost only $1: the price is what you see.

Nano options are based on 1/10th the value of the S&P 500 Index, using index symbol NANOS. So if the S&P 500 index is at 5300, then the NANO index = 530, so an at-the-money nano option would have a strike of 530. Each point in the nano index, which is = 10 points in the S&P 500 Index, is worth $1 and the minimum tick is 0.01, or one penny. Normal trading hours are from 9:30 AM to 4:15 PM, but trading in expiring options ends at 4 PM Eastern Time.

Nano options were designed by the CBOE for most traders who do not have the money to trade the full option contracts. Nano options also only have limited strike prices and are always issued with expiration dates no more than 1 week later.

Only a few brokers offer nano options. And because the prices for nano options are so low, normal option commissions, which usually range from $.65 to $1 per contract, would be a big cost of the contract, so commissions for trading nano options are much lower. Fidelity, for example, charges about 5% of the contract price, which is usually less than $0.10 per contract. Note, however, that the commission is a much larger part of the contract. For most option contracts with a multiplier of 100, the commission is 1% or less, so a 5% commission per contract is obviously much higher.

Like other index options, nano options are settled in cash. Nano options also receive favorable tax treatment where 60% of the gain is treated as long-term while the remainder 40% is treated as short-term regardless of how long the contract was actually held.

Nano Option Expiration days:

Examples: Calculating Cash Settlement Amounts for Nano Options

If, at expiration:

Then:

0DTE Options

A 0DTE option is an options contract that expires at the end of the current trading day. ODTE stands for 0 days till expiration. Although every options contract will have a 0-day expiration on its last day of existence, 0DTE options are options that expire on the same day they are issued, at 4:15 PM ET.

These options have become the most popular options traded because they’re cheap compared to other options, and the 0DTE index options, like other index options, are settled in cash. Since they exist for only 1 day, they have virtually no time value, so they are very sensitive to the value of the underlying index.

The 0DTE term mostly applies to SPDR S&P 500 ETF Trust (SPY), S&P 500 Index (SPX), Nasdaq 100 Index (NDX), and the Invesco QQQ ETF Trust Series I (QQQ) options. The index options are settled with cash, and the ETF options are settled with shares, just like stock options.