The options dilemma

There's a whole lot for options traders to chose from these days, particularly in the arena of equity-linked products. When you're looking for exposure in the market, where you turn can have a significant effect on your ultimate bottom line.

Indeed, new equity index and exchange-traded funds (ETFs) continue to be introduced. The main difference between an index and an ETF is that indexes are cash-settled and ETFs are underlying-unit settled (normally shares). There also are ETFs based on indexes. For example, SPDRs are ETFs based on the S&P 500 index. Because most of these products have options based upon them, this proliferation of equity products provides an array of choices for the option trader (see "A full plate," below).

When faced with similar trading vehicles in the equity and futures markets, traders need to consider the differences between the options. Here, using a few examples of similar products in different sectors, we'll look at the advantages of selling options on equities vs. selling options on futures.

WHICH S&P?

The S&P 500 is the most watched stock index in the world. It only makes sense to examine the differences in investing in two of the most popular trading vehicles based on this index. First, let's look at trading options on the S&P 500 cash index (SPX) and options on the E-Mini S&P 500 index futures. The cash index trades on the equity market. The E-mini S&Ps trade on the Chicago Mercantile Exchange's (CME) Globex platform.

For example purposes, we'll follow trades that sell naked out-of-the-money puts on these two products to delineate the similarities and differences. Margin rates and commissions will be applied for a real-world look at the trade. For full disclosure, these rates and commissions are based on the Interactive Broker rates at the time this article was written.

Here are some of the fundamental differences between these products: The average volume on the SPX is about 285,000 options per day and the average volume on E-mini S&P futures (ES) is about 20,000 options per day. Both contracts have monthly options that expire on the same day of each month (the third Friday). As far as price movement, the charts (troughs and peaks) of these two products will be the same (see "Two markets, one path," right).

However, the futures contract listings for ES are by the March quarterly cycle (contracts are listed in March, June, September and December), which are the underlying index months for the monthly options. Thus, the ES index is higher than the SPX because it includes a cost-of-carry factor that amounts to the dividend that would be paid by the 500 stocks in the SPX. This accounts for the price differential between ES and the cash SPX index. However, as ES approaches expiration, it will converge to the value of SPX.

A key difference will be the margin that must be deposited to trade each product. To sell naked puts, the brokerage firm requires a deposit called "option margin." This is different than stock margin. The option margin is set aside and earns interest; it is not borrowed money like stock margin. There are two types of options margin. Initial margin is the deposit required to maintain a short option contract. Maintenance margin is the amount of margin that is needed before a margin call is generated. The maintenance margin is not in addition to the initial margin. Maintenance margin can be considered a subset of initial margin.

The margin requirements for equity options are well documented by the brokerage firms. Interactive Broker's margin for an equity index is 15% of the underlying security. This 15% is increased or decreased depending upon whether the strike is in- or out-of-themoney. The amount of time before expiration is not part of the equity equation. The margin requirement for futures options is computed by a software program called SPAN, which is short for Standardized Portfolio Analysis of Risk. It calculates the initial margin based on several scenarios called risk arrays. The PC version of SPAN program can be purchased for about $500.

The margin on these products can be considerably different (see "Tale of two margins," right). As you can seen in the table, selling naked puts on the SPX is monetarily restrictive for most traders, but selling naked outof-the-money options on ES is an affordable alternative.

How these two trades play out is quite different. "It adds up..." (page 36) shows the results of the trade that was made at the end of February expiration. One option unit on the SPX is $100 and one option unit on the ES is $50. Therefore, in this trade, twice as many ES contacts were sold to produce about the same profit.

Because of the low futures margin, the monthly profit percentage for ES is much higher. The loss is the same for either of these products at expiration because they both will be at the cash price. For each point that the option closes in-the-money, a $1,000 loss is incurred if the position is closed.

BROADER-BASED

The S&P is not the only stock index that displays considerable differences in the end result of options trades based on different underlyings. We also can see this in products based on the Russell 2000; in this case, the iShares Russell 2000 Index Fund (IWM), an active ETF traded on the Russell 2000, and the Russell 2000 (RL2), an actively traded futures at the CME.

In terms of their price charts, these products are obviously very similar (see "Which Russell?" right), but that doesn't necessarily mean these two trades will result in the same profits.

Both have monthly options that expire on the same day. As with ES, the futures contract listing for RL2 is by the March quarterly cycle. The RL2 product is greater than IWM by a multiplication factor of 10 and also has a cost-to-carry. However, within a few hours of the expiration date, the index prices converge (except for this multiplication factor).

Because a one-point drop in the IWM is equivalent to a 10-point drop in RL2, options are more expensive on RL2. As would be expected, with a month before expiration, an at-themoney option on IWM is about 1.2 and on the RL2, it is about 12.

The strategy for this trade is to sell out-of-the-money puts by about 14% on each product. The relative loss is the same for either of these products at expiration. As with the S&P positions, for each point that the option closes in-the-money, a $1,000 loss is incurred to close the position.

However, if these products were to drop by 14% with about three weeks left before expiration, the cost to close the RL2 position would be much greater than the IWM position. Therefore, RL2 offers a greater reward but also a greater risk if the contracts have to be closed out before expiration.

To see how trades on these two options performed, see "The power of leverage" (right). Again, because of the low futures margin, the monthly profit is much higher.

For selling options, the lower futures margin requirement offers a big advantage versus equity-based options on similar underlying products. Although only selling naked options was discussed, the same margin advantage is present for option spread traders. The bottom line: "Go futures."