Lessons from the Pros


Options – Not Just for Stocks

Many people are familiar with puts and calls on stocks. The fact is, however, that there are options on other types of assets too. Some of them may be attractive to you.

The type of optionable underlying asset most similar to stocks is the exchange-traded fund (ETF). The options on ETFs work just like the options on stocks, but the ETFs can be better than stocks for certain types of option trades. This is because each ETF represents more than just the stock of one company. Many track the levels of stock indexes, like SPY for the S&P 500, QQQ for the NASDAQ 100 and IWM for the Russell 2000. Because the ETF represents dozens or hundreds of stocks, it is not as vulnerable to violent price movements as an individual stock. This can be a very good thing when you are doing the type of option trading called premium selling, or credit trading.

Free Trading WorkshopIn this type of trading an investor sells options short, collecting money from the sale. The investor hopes and expects that the underlying asset will not go beyond the strike price of the options he has sold. The investor is not looking for much of a move on the stock in one direction; he just wants it not to move in the opposite direction.

This type of trade can be done in a bullish fashion by selling put options whose strike price is below a level that the investor believes the ETF will not drop through. It can also be done in a bearish fashion by selling calls with a strike price above a level that the investor believes the ETF will not rise above.

This can be a very profitable type of trade. With carefully selected strike prices, these trades have a high probability of making money. The underlying asset does not have to move in the investor’s anticipated direction for these trades to pay off. It just has to not move too much in the wrong direction. For this reason, credit trades, when done using out-of-the-money options, have a better-than even chance of being profitable to some degree.

The issue with credit trading, though, is that the maximum payoff is limited while the risk is not. Although profit is more than likely, it is limited to the amount of money received for selling the options. What the credit trader most emphatically does not want is a sudden, sharp move through the strike price of the short options. This could lead to a loss that will wipe out the profits from many successful trades.

Trading options on ETFs when doing credit trades can reduce the risk from a sudden unexpected move.

ETFs also give us opportunities to invest in non-equity assets like commodities, gold and bonds.

The next type of underlying asset that investors can consider is options on equity indexes. There are many of these, including the same ones I mentioned above when talking about ETFs. Options are available on the indexes themselves, including the S&P 500, the NASDAQ 100, the Russell 2000 and many more. The levels of the indexes, of course, are what the ETFs based on those indexes are tracking. So why choose one over the other? Each share of the SPY ETF, for example, represents 1/10th of the value of the S&P 500 index. If the S&P is at 2050, SPY should be at $205. So why would one option contract on the S&P 500 at 2050 be different from 10 contracts on SPY at 205?

The answer is tax treatment. In the United States, long-term capital gains are taxed at lower rates than short-term capital gains or other income. Options on indexes fall under Section 1256 of the Internal Revenue Code. This section gives preferential treatment to the options on indexes (as well as to some other things, such as futures contracts and foreign currency contracts). Any gains made on index options are taxed as if 60% of the gain was a long-term capital gain, no matter how long the position is held. The remaining 40% of the gain is taxed at short-term capital gains rates, which are the same as ordinary income tax rates. The tax savings can be substantial.

It may seem strange that options on the same thing in two slightly different forms are taxed in different ways. After all, the pretax profit from a given option strategy on either the S&P index or on the S&P ETF would yield the same results, if adjusted for position size. Why should they be taxed differently? Just remember that this is a tax law – it doesn’t have to make sense.

Speaking of Section 1256, those other items that fall under it – futures contracts and forex contracts – have their own options. These options also have the special tax treatment. They have an additional layer of abstraction – they are derivatives of derivatives.

Although the compound-leverage options on derivatives are probably not the type of options to cut your teeth on as a new option trader, the options on ETFs and on indexes can be used by anyone. Do yourself a favor and check into these as possibilities for your own option trades. Learn more by signing up for Online Trading Academy’s Professional Option Trader Course. Contact your local center for more information.

DISCLAIMER This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.

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