How does the S&P500 option chain relate to the S&P ETF options?

Question

The S&P 500 itself seems straightforward enough: It's what you would get if you bought a little bit of the largest companies on the market. I understand that there are also options on the index, which are based not on shares but cash equivalent to the value of the index.

However, now many companies also offer S&P ETFs. The major ones track the index very closely and have sizable weight themselves. For example, SPY by itself is apparently about $200B in assets, meanwhile the S&P500 together are $18.5T. So SPY alone is already 1% of the S&P. On top of that, I imagine not all of that $18.5T is invested "in the index" per se, there are a lot of shares held as individual stock picks by investors who are thus not really part of your "index trading pool", since their behavior is influenced by something (that individual company), which has very little relation (1 in 500!) to what an index investor trades (either a huge basket of shares or more realistically an ETF, which is itself a basket of shares). So surely the impact of the SPY on the S&P index market is even greater than the 1% figure implies. And then there are also other sizable funds, like IVV and VOO.

These ETFs also all have their own option chains. Let's consider only the at-the-money (more precisely, the first in-the-money strike) calls expiring Sep 16 2016:

• For SPX (I would get cash, not shares) calls at 2180, the open interest is 42k and IV is 9.35%.
• For SPY calls at 218 the OI is 72k, and IV is 8.97%. 218.5 is also ITM but strangely the OI is 0.
• For IVV calls at 215, OI is 1301, IV is 12%.
• For VOO calls at 200, OI is 98 (even though VOO is about 2/3s as big as IVV) and IV is 9.52%.

This seems like a pretty big difference, and it is not correlated to the market caps at all! Note that these calls all represent bets on the same probability: That of the S&P not moving much above its current level by Sep 16. Well, technically the latter ones are bets on the ETFs not moving above, but what are the odds of the ETFs moving without the index? These are very large ETFs ran by serious companies!

Suppose I wanted to "invest in the index", specifically via options. Of course I must first understand what options and stock to actually buy, but I must also understand what factors influence the market.

With a single stock, like AAPL, it's easy: You have the AAPL shares, you have the AAPL options, and then you have the external factors. With the S&P, I'm very confused. There seem to be different, parallel markets for both shares and options, and while the ETFs track closely, the options don't appear to have been arbitraged to the point of only trivial separation.

Specifically, I feel like I could start trading options in IVV, and this could affect the options in SPY, and if I only paid attention to the IVV option market I could be blindsided by the SPY traders, since from my perspective it would act like a shadow pool. So it seems that I must keep track of every major S&P ETF as well as the index itself, which is itself impossible, since I don't know how many people out there actually hold a basket of S&P shares as opposed to small subsets of it. But also, surely the price of the underlying must be affected by the option traders (in fact some option strategies involve trading the underlying, like covered calls), but how can these ETFs correlate so well if their option chains are so different?

How do people who trade S&P options deal with this confusion? Is there some simple rule of thumb? Do they just pick one ETF and pretend the rest of the world doesn't exist? Are they constantly evaluating arbitrage potential, by running the calculations of a trade through every separate ETF market first? Is there a way to somehow synthesize these separate markets into a sort of S&P "metamarket" and "meta option chain" that is fully informative?

Answer 1

ETF Correlation

Ultimately how much a security tracks the S&P 500 comes from the ability to convert that asset into the shares of the companies in the S&P 500.

For example, if you have 400,000 shares of the SPY ETF, you can have them redeemed to the corresponding shares of the companies within the S&P 500 index. This mechanism allows the SPY to closely follow the companies very closely as if it diverged too far, a market participant would be able to go in and buy SPY, convert them to the 500 securities in the S&P 500 index and sell them at a profit (or vice versa).

There is a little deviation however, for example SPY has an expense ratio of 0.09% per year, so might not track the S&P 500 as closely over the long term. Redemption fees may also factor in.

However, as you mention, you see that SPX, SPY and the other funds like IVV and VOO track very closely.

Does OI and IV represent correlation?

I would argue that neither Open Interest (OI) nor Implied Volatility indicate correlation.

Open Interest (OI) is a measure of how many of those options are outstanding, which in turn is a rough indication of how heavily the options have traded. A high OI simply indicates how popular that particular options strike is. You also have to factor in the fact that some options underlying is priced higher and have higher multipliers, so one unit of OI for SPX is equivalent to about 250 units of SPY OI.

Implied Volatility (IV) is determined from the option price, working backwards to come up with what volatility is implied by the option price. As there is a spread between the bid and ask, the bid will have a lower IV than the ask IV. The IV shown to you could be calculated either from the bid, the ask or the midpoint. The best they can provide is a range. Seeing variation among options is more of an indication of variances in spread and the interest of the market in the security.

S&P Confusion

As stated above, the OI and IV is not a measure of correlation. The options relate to the specific underlying security they overly. As the underlying securities correlate, it makes them to some extent substitutable.

For example. if you sold an SPY call option, you could buy a IVV option at an equivalent strike. If you were assigned SPY, you could exercise your IVV option to get rid of equivalent IVV, then sell the SPY to buy back IVV. This would make the options in the different S&P 500 instruments equivalent except that you would have the transaction costs associated with the additional steps.

Activity in the options market in these ETFs could have some impact in the overall market, but in general, these are likely to be insignificant (so people don't have to worry about what happens in these markets to trade SPX options).

Other Differences

As the SPX options are index options they follow a "European" exercise regime rather than an "American" exercise regime. "American" options can be exercised any day prior to expiration, while "European" options can only be exercised at expiration.