Index Options vs. Equity Options: 5 Key Differences
Stock options (also known as equity options) trading hit its 50th anniversary in 2023, and now it’s more popular than ever.(1) This trend may not come as too much of a surprise, since options can offer multiple potential benefits, including risk management, diversification, hedging, and different strategies to help build your portfolio(2).
Besides the well-known equity options, options trading also includes index options. Some investors are less familiar with these, which have also been growing in usage and popularity. Depending on your experience, risk tolerance, desired trading strategies, and investment goals, index options may be a useful product for you to explore and add to your portfolio.
Both equity options and index options rely on underlying assets, but there are some key differences you should know. Read on to find out about these and consider which product may fit your investment goals.
What is an option?
An option is a financial derivative that gives an investor (known as the option holder) the right, but not the obligation, to buy or sell an underlying asset with a set quantity by a specific date at a specified price.
If you are the seller (or the writer) of this option, then you accept the obligation to buy or sell should the buyer exercise their right as noted in the contract specifics.
For U.S. investors, they can trade options on a broad range of financial products, including stocks, exchange-traded funds (ETFs), indexes, and more.
What are equity options?
Equity options are contracts that give the holder (buyer of the option) the right, but not the obligation, to either buy or sell a security at a set strike price on or prior to the contract’s expiration date. Equity options include calls and put options.
What are index options?
Index options are contracts that have a benchmark index, such as the S&P 500, as its underlying asset. They also give the holder (the buyer) the right, but not the obligation, to either buy or sell this underlying benchmark index, at a specified strike price. Index options include calls and puts, like equity options.
How do index options differ from equity options?
Aside from different underlying assets, index options and equity options are influenced by similar factors. These include the value of the underlying asset, strike price, volatility, time to expiration, and interest rates; however, differences include index options typically require more capital in your account vs many equity options and Index options only offer a few choices that are relatively higher priced vs equity options, in general.
If you're considering trading index options or equity options, it's important to understand five key differences. Let's dive in and break it down.
Diversification: One stock vs. Multiple underlying stocks
With options you’ll find many options!
With an equity options’ underlying assets based on a single company’s stock, there’s a wide world of optionable stocks, which are stocks that have listed options on them, available for trading. This number comes in around 6,000 stocks.
Amazon.com Inc. and Apple Inc. are two examples of actively traded equity options.
Meanwhile, index options with their benchmark indices encompass multiple stocks instead of a single stock. Index options don’t trade stocks individually; instead, you’re trading options based on the single index and the number of index options choices are vastly smaller than equity options.
With its many stocks, an index can be narrow based, which includes nine or fewer component securities making up a particular sector, such as oil and gas or airline stocks.
A broad-based index is a benchmark that tracks a large group of stocks’ performance that has been selected to represent the broader stock market. Among the index options list, examples include the popular S&P 500 (SPX) and the Dow Jones Industrial Average (DJX).
Different exercise style: American vs. European
Another key difference that sets index options apart from equity options is their different exercise styles. Note that equity options and index options may expire and settle on different days than Fridays and Thursdays respectively, depending on the option.
Here’s a example to highlight the differences.
Some key differences include exercising before expiration vs not being able to do so and a stock transfer vs a cash settlement. For index options, the European exercise style can get rid of the risk for an early exercise or assignment because they can only be exercised at their expiration.
Settlement method: Physical delivery vs. Cash
Not only do equity options and index options have different exercise styles, but they also have different settlement styles.
For equity options, think, let’s get physical.
Equity options are settled by taking physical delivery of the underlying shares of the stock when they are either exercised or assigned. For example, if a call option is in-the-money at expiration (the stock’s current market price is higher than the option’s strike price), the option will be exchanged for shares in the underlying security.
Index options settlement brings cash.
Index options are cash settled for the index’s value. They are also typically European style, which means they settle on the expiration date. At expiration, they will be paid out in cash through a trading account that will be debited or credited in cash.
Different tax treatment: 60/40 vs. Short-term capital gains
Another reason why some investors like to trade index options? Potential capital gains from trading index options are eligible for a hybrid treatment. This is because under the current Internal Revenue code, index options are designated as 1256 contracts, which get the 60/40 tax treatment, regardless of the holding period.
The holding period refers to the amount of time the investor holds their investment.
Before we explain, here’s a note: Market participants should consult with their tax advisors to determine how the profit and loss on any particular option strategy will be taxed. Tax laws and regulations change from time to time and may be subject to varying interpretations. Moomoo Financial and its affiliates do not provide tax advice and any tax-related information provided is general in nature and should not be considered personalized tax advice.
So how does the 60/40 tax treatment work?
In a nutshell: when a trade earns a profit, 60% of it is treated as long-term capital gains, while 40% is treated as short-term capital gains and taxed as ordinary income(3). Here’s the difference.
Long-term capital gains: Gains that come from selling an asset that you’ve had for longer than one year. These are typically taxed between 0% to 20%, depending on an investor’s taxable income.
Short-term capital gains: Gains made from selling an asset that you’ve held for a year or less. The tax rate for this is the same as an investor’s ordinary income, ranging between 10% to 37%
Let’s look at a hypothetical trade to illustrate how the 60/40 tax treatment works for index options vs an equity options’ tax treatment.
Here’s the scenario: an investor trades an index option (or an equity option) with a one-week holding period and captures $100 in gains. Note: for these examples we use the highest rate but depending on an investor’s income, the taxes could be less.
An additional difference is 1256 contracts are also not subject to the same wash sales rules as equities. A wash sale occurs when an investor buys a security either 30 days before or 30 days after selling the same or similar security. The IRS has a wash sale rule that prevents investors from advantageously using capital losses at tax time.
Note: Example provided for illustrative purposes only. Actual results will vary. Moomoo Financial and its affiliates do not provide tax advice and any tax-related information provided is general in nature and should not be considered personalized tax advice.
Volatility: Diversity of stocks vs a single stock
The statement less is more can be applied to how volatility affects index options vs equity options.
With its basket of stocks within the index vs an equity option’s single stock, index options are less volatile because of their diversity. They also have greater predictability and the up and down swings in the stocks tend to cancel each other out.
However, during times of volatility due to news events or earnings reports, stock options prices are generally more impacted than index options.
What does moomoo offer for options traders?
When it comes to trading options — whether you lean toward equity options, index options or both — you need a broker and platform that can help meet your needs and goals.
With moomoo, commission-free(1) options trading is one reason investors may come to our platform but investors across all different levels can also enjoy these features and tools, including:
Equity and index options trading (brokerage account required, subject to eligibility requirements)
Customizable options chains and filters with real-time data
Unusual options activity to detect significant market changes
Built-in options price calculator to estimate theoretical values with multiple models and real-time Greeks
In-depth analyses of volatility, profit and loss, and more
Sources:
1. Through the storm? Options usage trend to end 2022 and start 2023
2. https://www.optionseducation.org/advancedconcepts/equity-vs-index-options
3. https://www.nerdwallet.com/article/taxes/capital-gains-tax-rates.