ETF Options,Indexes, and HOLDRs

So far, we’ve focused on equity options—options on individual stocks. But investors have other choices for trading securities options. Options on baskets of stocks can be traded, too. This can be accomplished using options on exchange-traded funds (ETFs), index options, or options on holding company depositary receipts (HOLDRs).ETF Options:Exchange-traded funds are vehicles that represent ownership in a fund or investment trust.

This fund is made up of a basket of an underlying index’s securities—usually equities. The contract specifications of ETF options are similar to those of equity options. Let’s look at an example.One actively traded optionable ETF is the Standard & Poor’s Depositary Receipts (SPDRs or Spiders). Spider shares and options trade under the symbol SPY. Exercising one SPY call gives the exerciser a long position of 100 shares of Spiders at the strike price of the option.

Expiration for ETF options typically falls on the same day as for equity options—the Saturday following the third Friday of the month.ETF options are American exercise. Traders of ETFs should be aware of the relationship between the price of the ETF shares and the value of the underlying index. For example, the stated value of the Spiders is about one tenth the stated value of the S&P 500.

The PowerShares QQQ ETF,representing the Nasdaq 100, is about one fortieth the stated value of the Nasdaq 100.Index Options:Trading options on the Spiders ETF is a convenient way to trade the Standard & Poor’s (S&P) 500. But it’s not the only way. There are other option contracts listed on the S&P 500. The SPX is one of the major ones.The SPX is an index option contract.

There are some very important differences between ETF options like SPY and index options like SPX.The first difference is the underlying. The underlying for ETF options is 100 shares of the ETF. The underlying for index options is the numerical value of the index. So if the S&P 500 is at 1303.50, the underlying for SPX options is 1303.50. When an SPX call option is exercised, instead of getting 100 shares of something, the exerciser gets the ITM cash value of the option times $100.

Again, with SPX at 1303.50, if a 1300 call is exercised, the exerciser gets $350—that’s 1303.50 minus 1300, times $100. This is called cash settlement.Many index options are European, which means no early exercise.At expiration, any long ITM options in a trader’s inventory result in an account credit; any short ITMs result in a debit of the ITM value times $100. The settlement process for determining whether a European-style index option is in-the-money at expiration is a little different, too. Often,these indexes are a.m. settled.

A.m.-settled index options will have actual expiration on the conventional Saturday following the third Friday of the month. But the final trading day is the Thursday before the expiration day.The final settlement value of the index is determined by the opening prices of the components of the index on Friday morning.HOLDR Options:Like ETFs, holding company depositary receipts also represent ownership in a basket of stocks.

The main difference is that investors owning HOLDRs retain the ownership rights of the individual stocks in the fund, such as the right to vote shares and the right to receive dividends. Options on HOLDRs,for all intents and purposes, function much like options on ETFs.Strategies and At-Expiration Diagrams One of the great strengths of options is that there are so many different ways to use them.

There are simple, straightforward strategies like buying a call.And there are complex spreads with creative names like jelly roll, guts, and iron butterfly. A spread is a strategy that involves combining an option with one or more other options or stock. Each component of the spread is referred to as a leg.Each spread has its own unique risk and reward characteristics that make it appropriate for certain market outlooks.

Throughout this book, many different spreads will be discussed in depth. For now, it’s important to understand that all spreads are made up of a combination of four basic option positions: buy call, sell call, buy put, and sell put. Understanding complex option strategies requires understanding these basic positions and their common, practical uses. When learning options, it’s helpful to see what the option’s payout is if it is held until expiration.