The financial market landscape offers a wide assortment of financial products and services. A good part of the products can be found in the derivatives market. One of the trading products which can be found in the derivatives market is “Cash Settled” Index Options not to be confused with “ETF” Index Options. As the name indicates cash settled index options are settled in cash not with the underlying stock as with ETF index options. ETF index options are well known, such as SPY and QQQ, so we will not discuss them in this post, we will only discuss cash-settled index options.
European Style Index Options
European style option indexes are cash settled indexes that can only be exercised on the expiration date. European style indexes are the only type of index used with cash settled indexes. European Index Options that are cash settled only trade options no underlying stock is attached. When trading European style cash settled indexes you don’t have to worry about receiving stock or paying dividends. Cash settled means no other requirements.
Types of Cash Settled Option Indexes
Examples of cash settled index options that you can trade are S&P 500 Index (SPX), Nasdaq 100 Index (NDX), Russell 2000 Index (RUT), Volatility Index (VIX), Dow Jones Index (DJX), S&P 100 Index (OEX), and the S&P 500 Mini Index (XSP).
Tax Treatment for Cash Settled Indexes
All cash settled index options receive 1256 Contract tax treatment in the United States. 1256 Contracts are taxed at 60% long-term gain rates and 40% short-term gain rates. In contrast equities are all taxed at short term capital gain rates if held for less than 12-months. In addition, 1256 Contracts are priced mark-to-market, so they don’t require the accounting of individual trades like equities. Therefore, this makes determining the cost basis for positions not necessary. Taxes on cash settled indexes are straight forward and require no trade by trade accounting.
How to Trade Cash Settled Index Options
When trading cash settled indexes that we have discussed in this post you have to understand that each one point move equals $100. For example, if the S&P 500 (SPX) is trading at 2,800 and it goes down to 2,795, the cash amount exchanged is $500 not $5. The multiplier is 100 for every point move. Cash settled index options can be bought or sold. I prefer to sell options over buying them because when buying options I have at best a 50% probability of making money just like buying stocks. However, with selling options I can have a 99% probability of making money if I decide that’s the type of option I want to sell based on deltas. However, this post is not about probabilities and deltas, if you would like to learn more about selling options based on probabilities and deltas, you can read other posts within our blog or visit www.tastytrade.com. For the purposes of this post, the following trade is used to demonstrate how trading a cash settled index works (not real pricing):
SPX is trading at 2,850 on July 26, 2018
Sell the Aug 2018, 2,800 put strike for $2.25
Buy the Aug 2018, 2,795 put strike for $1.00
Total collected is $2.25 – $1.00 or $1.25
The example provided is called a short put spread or bull put spread. Your max gain on the trade is $125 which is the premium received for selling the put spread. Your max loss is $375. Which equals $500 from the difference in the 2,800 and 2,795 put strikes (remember the 100 multiplier) minus $125 from the premium received for selling the put spread. This trade makes money as long as the SPX doesn’t trade below 2,675 (not including commissions).
If this is the first time you have been introduced to cash settled indexes then you should consider leaning more about them. Cash settled indexes can be a great vehicle to trade especially because you don’t have to worry about receiving stock, paying dividends, or cost basis accounting. Some traders and firms including the Dorian Fund trade exclusively with instruments that meet 1256 Contract requirements.