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What is the criteria one should use before deciding on an underlying to trade options on: 1.Options on SPX (Cash settled, European style) 2.Options on SPY ( Settled in SPY shares, American style)

This happens all the time, so the generic question is...whether to trade options on the index itself or on ETF that tracks the index.

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Unless the ETF diverges from the index, the outcome will essentially be the same. So you should base your decision on the characteristics of the options:

  • style: European vs American and cash vs physical, which is somewhat neutral
  • size (SPY options notional is around $20k vs $200k for SPX options): using SPY options is probably easier for an individual
  • execution cost: SPY options tend to be have tighter spreads than SPX options - right now for example on the 205/2050 puts, SPY is 3.73/3.75 (0.5% bid/ask spread) vs 33.1/34.7 (5% spread)
  • the dividends streams are different (once a quarter for SPY, potentially every day for SPX)

All in all, SPY options seem a better fit for an individual.

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