Two very popular options to trade are in the SPX S&P500 cash settled index and the SPY S&P500 ETF. Each offers unique benefits for options traders. Listen to this week's podcast to hear about the key differences between the SPX and SPY and some strategies for trading each.
Sarah: Hi everybody, this is Sarah Potter welcome to the SCT podcast. We are in episode 36 and while I completely understand that when we do podcasts everybody is listening to podcasts at different times. TJ and I definitely wanted to highlight and have a discussion about something that's very relevant for this week. Now certainly our topic is going to be good for any of the weeks that are trading but it's especially important this week. So this week if you look at the market there's a lot going on. We have a lot of news, a lot of earnings, we have FOMC does a lot. So if you are even if you're not even an options trader, if you just trade stock, if you're just investing in the market this is a big week and we want to expect or anticipate that we will have relative moves to that. So what that means then is we're going to have many perhaps many of the stocks or trading instruments that you look at might look a little different. So what we decided to do is talk about some different opportunities to trade or different instruments to look at. So we're going to talk today about the differences between a cash-settled index versus ETFs. Now you guys know that we both like to trade those and certainly those are different instruments and they have different characteristics so we thought let's get into that so that people understand what they are like to trade and perhaps those are things you might want to go look at when you have a week on deck that has a lot of different news. So hi TJ.
TJ: Good afternoon.
Sarah: You like to trade the SPX a lot and I know that that's something that you do in the trading room and I would definitely say that you're really good at that. So could you start us off by explaining a little bit about what is a cash settle index and its characteristics?
TJ: Okay, sure. I guess let's compare how to trade indexes. So the two basic ways our cash settle index like the SPX and any TF like the SPY so the major difference between the two is the SPX is cash settled. So that means you will never be assigned shares of the SPX, there are no shares to be assign. The SPX you can only trade options on the index. So at settlement if you are in the money, you either have money put in your cash, put in your account or cash taken out of your trading account instead of a typical option where you would have shares assigned to you. The SPY is an ETF so you can buy shares in the SPY so if an expiration day you are assigned you actually get the shares so that is the main difference between the two. The other differences is just the size of the contract the SPX is about ten times the value of the SPY so that comes into position sizing as well and we can talk a little bit more about that maybe later in the podcast. And the other major difference is how they expire and we'll about that a little bit I guess later or we can get into that right now, what do you think Sarah?
Sarah: Sure, I mean I think expiry is a really important piece because that's something that when we get questions about when we're trading these instruments people don't sometimes realize that things can expire at different times especially in the SPX. So let's get to that. So this is a week that has a lot of earnings and new so especially Wednesday's FOMC and then SPX has expired on Wednesday. So in particular you like to trade SPX. Would you ever trade an SPX trade and have it expire on the same day that you have an FOMC announcement?
TJ: You could, that would be a lot like an earnings trade you know the market has expectations and obviously you're expecting a big move so you can definitely set it up. Is that my strategy? No, that's typically not my strategy. The two strategies I really like are overnight trade in the SPX so basically holding it, buying at the day before expiration, setting up the trade holding it overnight and letting it expire the next day. The other trade that I really like is also today trade. So to look for you know potential credit spreads on a Friday. However we do have to look at and we can talk about this as well that those two trades primarily work best when there's higher implied volatility in the market and right now if anyone's paying attention to the SPX, I mean we know that I mean IV was you know a couple weeks ago even if the last week was 8, 9 which is extremely-extremely low. So the credit is just not necessarily there for those types of trades but definitely those are the two setups that I prefer when I do trade it.
Sarah: But when the implied volatility be going up this week like perhaps this is a week that you want to pay attention to SPX because of all the news?
TJ: Yeah, you would you would think that that FOMC would actually you know really make a difference in it, but it's actually it's not, it's not changing implied volatility, we're just even if we look at the VIX it's just pegged it right at the lows I mean we were talking about it in the trading room a couple weeks ago how you know we were down in the low 9s on the VIX and you know we had to look back 11 years, we had to look back you know almost 11 years back to 2007 before we really saw levels below 9 and I think it was a VIX with eight and a half, 8.5 I think was approximately the number that we saw and that was back in 2007 and we know what happened. You know I have you know six months to a year later we had the big crash of 2008 and no I'm not saying that what we're seeing now is it all the same, I'm just trying to say that you know we're at really-really low levels and you know the VIX doesn't really want to go lower but it doesn't want to go higher either because the market does keep going up. So you know it's kind of stuck in a range and Daphne you know events that we would typically see an increase in volatility a little bit but not enough to really make a difference in trading.
Sarah: Okay. So those kind of change gears and start talking about ETF. So I know that in the trading room I get asked about SPY a lot it seems to be very popular instrument to trade and I want to specifically talk about it, obviously you guys all know that we both look at the ES which is the futures contract but they all represent the same thing, right? So this is the SNP and SPY in particular it is ETF so it's cheaper. So I think a lot of people really like to trade it because it doesn't cost as much to trade but I don't know about you but sometimes I find if I place trades or if I even look for trades and SPY it can be actually difficult to be able to actually get filled on a tray that you really like the charts can look really nice but when we move into the options chain sometimes to just things don't really line up. So a lot of times I'm not actually going to follow through on that trade because we can't see stuff except for weeks like this when you now have more news, more events that might potentially move the market if you are fearful of placing a trade, a futures trade in the ES or the SPX business setting up SPY can actually be a really good instrument right now.
TJ: Yeah, I mean absolutely. I think that we have to keep in mind too what you brought up is absolutely right. So I mean we think about if we're getting say we're doing a credit spread in SPX and we're getting 30 cents you know we're potentially looking at 3 cents of credit in the SPY so it really doesn't make sense to almost trade for that 3 cents. So I think you know we may differ in that opinion is, I really rarely look at the SPY and I don't I don't really see the advantage to it.
Sarah: Really? I can buy a call and SPY and have so much less risk because I don't have to put up as much in the trade and still be able to take advantage of the moves that can happen in the broader markets obviously the ETF is a representation of that. So I don't know, I like that, so to me looking out it this week and seeing, oh yeah, I expect the market to move quite a bit I think SPY is actually a really great trading instrument that I do want to be involved in because I don't have to put the risk up. Now you're probably talking about spreads, right? And trying to place a spread trade in SPYs almost impossible sometimes.
TJ: Exactly and I think too that. Yeah, I guess if you're looking to buy puts and calls I do agree that we’re, yeah so it's a little bit cost prohibitive in the SPX. I mean you can be 20 points out on a put or a call you know risking two thousand dollars on per contract whereas you could do that risk two hundred dollars per contract in the SPX which is probably more in alignment. So I guess if you think about it that way, yeah I guess they're useful for different reasons.
Sarah: Yeah, so a piece about SPY that I definitely want to mention is that, just because those are cheaper calls and puts to buy again they don't necessarily mean that they're going to turn into crazy profits, right? So if you're buying something and you see risked a dollar and you make thirty to fifty dollars on that trade that is a huge return on investment and so I think where people get wrong, go down the wrong way there with SPY is they start saying well I'm not risking that much but I still want to make a huge amount so I'm just going to let that run, run and run and you need to keep that all relative to how that instrument likes to move. So remember that SPY is cheaper than the other ones for a reason and that also is going to mean at that range that you're looking for needs to all be aligned with what is realistic. So realistic set realistic profit targets in SPY and I think that can be a really great trading instrument especially for just buying straight calls and puts. But you don't ever do SPY you do SPX so if we were to ask you like of the ES the SPX and SPY, which one is your favorite and why?
TJ: That’s a really good question. I think I'm tied between the S&P, the ES contract, the options on futures, and the SPX depending on how I feel in terms of position sizing on that day, the ES contract is about half the size of the SPX give or take. So you can kind of fine-tune position sizing that way as well. So I'm kind of tied between the kind of between the two of them. One thing I do want to mention as well is that the cash settle index is like the SPX you have to remember that on monthly expiration, you have to trade a different contract. So every third week is a month if you want the contract that expires on Friday, you do need to trade the SPX p.m. contract because the SPX contract expires Thursday at the close but the pricing is based on Friday's open. So there's been quite a few traders who have been locked in, stuck in positions on you know overnight Thursday as the market gaps up Friday morning and a max profit goes into a loss and because the option stops trading on Thursday at the close but is still pricing Friday so you still see it in your account, the price is changing but you can't trade it. So it's really an odd situation if anyone's ever traded the SPX the third week and not realized that it expired the Thursday. Well that it stops trading the Thursday but again it's still pricing based on Friday's open and it's not even the open, it's the open of all 500 stocks in the S&P 500. So that doesn't even give you satisfaction when the market opens, it could be 5 or 10 minutes before they or 15 minutes before they figure out an actual settlement price. So just a little wrinkle there.
Sarah: A little wrinkle. I think that's why a lot of people are afraid to trade SPX because of the expire reason and all the rules and trying to keep that in mind. So I mean if it was what you just heard TJ described was too stressful for you just to keep that in mind I mean remember you can still trade SPY or you can do the ES and sometimes even though with the size of the ES if you're doing a futures contract you might think, oh gosh, remember it's still an auction too, right? You're still doing an option on the futures contract, it does the same thing as the options and everything else it's just a different underlying a different trading instrument. So you know if SPX and understanding all of its different expiries is not something you're interested in then don't forget that you can also do options on futures on the ES. However I also want to mention with the SPX because it does have the different expiry, there's times during the week where the Friday expiry doesn't look good on the options chain but the Wednesdays do. So it really just depends of that week, what actually looks to be setting up and don't forget that I went like, it’s almost like double the trade opportunities there so you can be pickier about the ones that you really want and when they do setup definitely pick the one that's tailored for you.
TJ: Exactly and one other thing too is I think that you know if we draw a line and we've got premium on one end and no premium on the other, you've got a stock like PCLN where there's ton of premium, there's a ton of people with different ideas, the index is like the SPX used by a lot of institutions for various reasons and they're priced pretty fairly in the market, there's not a lot of arbitrage, there's not a lot of you know a lot of profits, you know the sneaky profits if you want to call that to be had, it's pretty well traded, there's a lot of volume, a lot of institutions, a lot of big trading in the SPX, so if you see a lot of premium at a strike that you think is way out of the money and it'll never ever get there by Friday you know chances are there may be a good chance that it does, you know you don't get a lot of those opportunities to get that bonus premium like you might in a in a PCLN
Sarah: Yeah, I mean I think that's good. Remember, they all have different characteristics but there's always going to be times when each of those are good to trade. So if you're afraid of the market swinging too much then adjust to the contract size that you like but make sure you remember that within each of those contracts that your profit targets need to be relative to how those individual stocks move. I think that's a good discussion this week. Don't be afraid this week if the market don't be afraid of news just make sure you're tailoring your trades to make to remember that we do have news and that volatility will change things. So happy trading everybody.