Stein + Partners

Trading SPX Options vs SPY Options: Trading Advantages and Strategies

February 26, 2013 Presented by Peter B. Lusk @PeterLusk

Disclosures
In order to simplify the computations, commissions have not been included in the examples used in these materials. Commission costs will impact the outcome of all stock and options transactions and must be considered prior to entering into any transactions. Multiple-leg strategies involve multiple commission charges. Any strategies discussed, including examples using actual securities and price data, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities. Options involve risks and are not suitable for all investors. Prior to buying or selling an option, an investor must receive a copy of Characteristics and Risks of Standardized Options. Copies are available from your broker, by calling 1-888-OPTIONS, or from The Options Clearing Corporation, One North Wacker Drive, Suite 500, Chicago, Illinois 60606. Investors considering options should consult their tax advisor as to how taxes may affect the outcome of contemplated options transactions. CBOE and Chicago Board Options Exchange are registered trademarks and The Options Institute is a servicemark of CBOE. All other trademarks and servicemarks are the property of their respective owners. This presentation should not be construed as an endorsement or an indication by CBOE of the value of any non-CBOE product or service described in this presentation. Copyright 2013 Chicago Board Options Exchange, Incorporated. All rights reserved.
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Presentation Outline

Mechanics of Index Options SPX Specifications SPX versus SPY Protecting a Diversified Portfolio Option Price Behavior Strategies Summary

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Mechanics of Index Options

Index Option Contract
Index options function very much like stock options Both calls and puts are available for trading There are three major differences: Index options are settled through a cash transfer The majority of index options are European style contracts A potential tax benefit exists for index option traders

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Index Options vs. ETF Options

Stock options and ETF options are similar
The Underlying is 100 Shares Exercise/Assignment: Buy/Sell Shares

Index Options are different

The underlying is a cash value Exercise/Assignment: Receive/Pay Cash

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Index Options $100 Multiplier

The dollar cost of an index option is:

$100 times the stated option price SPX 1500 Call @ 37.00 Price of Option = $100 x 37 = $3,700

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The Cash Settlement Process

Example: SPX is 1538.53 at expiration Cash Value of a 1500 Call? SPX Value Less Strike Price Difference x Multiplier Cash from Seller to Buyer

1538.53 1500 38.53 x $100 $3853.00

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Mechanics of Index Options

Index vs. Equity Option Exercise Style
American Style Stock and ETF Options Can be exercised on any business day European Style Most Index Options (SPX) Can only be exercised at expiration

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Index Options - SPX

Ticker Symbol Underlying Multiplier Exercise Style Settlement Full Contract Size Tax Treatment SPX S&P 500 Stock Index $100 European AM 10 x SPY 60-40 (Broad-based index)

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60-40 Tax Treatment

1256 Contracts: Profits treated as 60% long term / 40% short term regardless of holding period Reported on Form 6781 and Schedule D Year end prices become cost basis for the new year

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Index Options
Tax Advantage ETF Options
Are treated like stock options*

Broad Based Index Options

Receive 60-40 Tax Treatment** 1256 Contracts
*Consult your tax advisor **According to Taxes and Investing, published by The Options Industry Council, available from http://www.cboe.com/LearnCenter/RCGeneral.asp Note: IRS regulations may change. Seek professional tax advice.
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Index Options
Broad Based Index Options include: S&P 100 OEX, XEO S&P 500 SPX, SPXpm, XSP CBOE Volatility Index - VIX

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SPX Comparison to SPY

Contract Comparison SPY is the SPDR S&P 500 ETF which represents ownership in a portfolio of stocks that replicates the S&P 500 Index. The underlying pricing for both SPX and SPY options is the S&P 500 Index December 2012 Volume
102,750,000 SPY Options 30,300,000 SPX Options
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SPX Comparison to SPY

Size Comparison
S&P 500 at 1450.00

1 SPY Option = 145.00 x 100 = $14,500 1 SPX Option = 1450.00 x $100 = $145,000
To control the same amount of market value 10 SPY contracts need to be traded for each SPX contract

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SPX Comparison to SPY

Size in Context
December Volume & S&P 500 at 1450.00: SPY 102,750,000 x 145.00 = $14,898,750,000 of market value SPX 30,300,000 x 1450.00 = $43,935,000,000 of market value
SPX is a much bigger market

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SPX Comparison to SPY

Contract Comparison Summary
S&P 500 at 1450.00
SPY 145.00 100 Shares American Style PM Buy / Sell Shares SPX 1450.00 $100.00 European Style Both Available Pay / Receive Cash

Underlying Value Contract Underlying American / European AM / PM Style Settlement

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Why SPX Options?

Larger notional side lower potential commissions
(10 to 1 ratio) Convenience of cash settled options versus physical delivery of shares No potential early exercise issues with SPX Preferred choice of sophisticated institutional traders Potential tax benefit

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Protecting a Diversified Portfolio

You own a $300,000 portfolio that closely
follows the SPX now at 1520 You are worried about a 15-20% market decline in the next 3 months. You want to limit downside risk and keep the upside.

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Protecting a Diversified Portfolio

Determine # of SPX contracts: Portfolio $Value to be Hedged Notional Value of Index Contract (Strike x $100) $300,000 = 2 SPX Puts 1520 x $100
Buy 2 SPX June 1520 Puts @ $40.00 ($4,000/Contract)

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Buying Index Puts

$300,000 Portfolio
SPX @ 1520 2 SPX ________ June 1520 Puts @ ______ 40 Buy____

2 x 40 x $100 = $8,000 Cost = __________________________ 2.6% of portfolio value 1 SPX Put protects $152,000 # of options = $300,000 $152,000 2 Strike price is at the money
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How the Protection Works

Assume SPX at 1,216 Market is down 20% so portfolio is down 20% $292,000 stock portfolio now $233,600 With SPX @ 1,216 1520 Puts @ _______ 304.00 Value of puts = _________________________ 304.00 x 2 x $100 = $60,800

233,600 + 60,800 = 294,400 Total Portfolio = ________________________

Market down 20%. You are down 2%

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Unwilling to Pay for Puts?

Sell equity calls to pay for index puts

Sell near-the-money calls on stocks that you are willing to sell now. Sell out-of-the-money calls on stocks that you are willing to sell if price rises. Sell calls on part of a stock position if you want to lighten up or diversify.

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More SPX & SPY Differences

SPY commission 20 contracts in and out SPX commissions 2 contracts in and out Tax consequences on put gain: SPX 1256 (60/40) SPY tax status uncertain SPY position turns into SPY shares if not closed, SPX settle in cash

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Option Price Behavior

Option Price Behavior

Delta: The amount an options theoretical price will change for a corresponding one-unit (point) change in the price of the underlying security. Gamma: The amount an options theoretical delta will change for a corresponding one-unit (point) change in the price of the underlying security. Theta: The amount an options theoretical price will change for a corresponding one-unit (day) change in the days to expiration of the option contract. Vega: The amount an options theoretical price will change for a corresponding one-unit (point) change in the implied volatility of the option contract.

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Option Price Behavior

Factors Impacting an Option Price: Stock Price Strike Price Days to Expiration Interest Rates Dividends Implied Volatility
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Long SPX Call

Long Call Example

S&P 500 quoted at 1450.00 We have a bullish outlook over the next two months
and expect market to rally 10% to 1600.00 by quarter end SPXQ options expire on last day of March To trade this positive outlook for the S&P 500 we decide to buy a call option

Buy 1 SPXQ Mar 1500 Call at 15.00

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Long Call Long 1 SPXQ Mar 1500 Call

Payoff Table SPX at Expiration 1400 1425 1450 1475 1500 1525 1550 1575 1600 SPXQ Mar 1500 Call Call Premium Profit / Loss 0.00 (15.00) (15.00) 0.00 (15.00) (15.00) 0.00 (15.00) (15.00) 0.00 (15.00) (15.00) 0.00 (15.00) (15.00) 25.00 10.00 (15.00) 50.00 35.00 (15.00) 75.00 (15.00) 60.00 100.00 (15.00) 85.00

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Long Call Long 1 SPXQ Mar 1500 Call

Payoff Diagram Market at 1450.00

Target is 1600.00

Break Even 1515.00 +4.4%

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SPX Debit Spread

Debit Spread
SPX Bull Call Spread: S&P 500 at 1320 Bullish on the stock market for next two months expect SPX at 1350 Focus on April expiration

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Debit Spread
SPX at 1320 58 Days to April Expiration SPX Bull Call Spread Buy 1 SPX Apr 1320 Call @ 31.00 Sell 1 SPX Apr 1350 Call @ 16.00 Net Debit = 15.00

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Debit Spread
Long 1 SPX Apr 1320 Call @ 31.00 Short 1 SPX Apr 1350 Call @ 16.00
1320 Call ITM 1320 & 1350 1350 CallCalls OTM Both ITM

1320 & 1350 Calls Expire OTM

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SPX Credit Spread

Credit Spread
Index Option Monthly Income Strategy Credit spread using OOM options Low dollar reward relative to risk

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SPX Credit Spread with Calls

SPX at 1460 Sell 1 Apr 1490 Call 1.45 Buy 1 Apr 1500 Call (.45) Net Credit
(45 Days to Expiration)
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1.00

SPX Credit Spread with Calls

Current Market

Max Loss = -9.00

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Credit Spreads
Credit Spreads Monthly Income Strategy Positives: Collect premium with limited risk Near zero exposure to volatility Negatives: Less return relative to naked short option trades
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Summary
SPX Options are an excellent method of gaining exposure to the S&P 500 Index SPX Index options get 60/40 tax treatment Three part forecast needed for option trades: underlying / time / implied vol Spreads offer unique trade-off www.cboe.com/spx

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Simply the Basics
Chicago, IL or Online March 8, 2013 9:00am to 12:00pm Simply the Basics is a half-day seminar that allows our experienced instructors to guide you towards understanding basic options trading concepts.

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Chicago, IL or Online March 21 & 22, 2013 This 2-day classroom experience plus 10 hours of distance coaching will introduce you to the basics of options and the basics of market timing, stock selection and risk management.

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CBOE 400 South LaSalle Street Chicago, Illinois 60605 Questions: @PeterLusk