The range of different derivatives available to invest in can make deciding which financial security you want to place your money into difficult, to say the least! Different products have slightly different pros and cons which will be dependent on things such as how much capital you are investing, the length of time you plan on holding your investments, as well as the tax implications of choosing one option, over another (Pro Tip: release your inner Starbucks and try to avoid paying as much tax as is legally possible).
SPOILER ALERT: This is a fairly in-depth and complex article, I suggest reading through it once, and then taking some notes on a second-run. It’s important to undertand the different investment products available to you, and you also want to know what you’re talking about when chatting to other traders (aim to be the top dog for the kudos if nothing else).
Standard and Poor's 500 serves as a great case study for investment options (options… not ‘options’ ;p), which consists of the United States’ 500 largest companies listed on the NYSE or NASDAQ. With most brokers or trading platforms you will find three primary ways of investing in the S&P 500.
The first two sub-sections detailed here are concerning options trading, where you can buy or sell options in the index itself (SPX), or you can buy or sell options in the ETF version of this index (SPY). For the purpose of this explanation, this will be classified as one method of trading the S&P 500 market (options trading), although it is important to note that there are differences between options trading in the SPX vs the SPY as both have distinct advantages and disadvantages depending which style of trading you use.
*if you are in Europe then it's likely you will be trading the SPX through a contract for difference (CFD), a product which is not available in USA, and is the reason why trading the index itself is done using options stateside. Confused yet? Keep reading.
You can purchase options in the index itself; if you wish to take this route then you’ll be trading in the market with the ticker symbol SPX. This index doesn’t actually trade, it is simply a visual representation as if it were a real life portfolio with the correct number of shares for each of the 500 companies. The companies included in this index are determined through their market capitalization, which is the value of their share price multiplied by how many shares they have outstanding. In simple terms it is the market value of a company’s outstanding shares. This means that the companies listed in the index can change intraday as companies value goes up and down.
The SPX is a capitalization-weighted index which means that larger weighted companies will have more impact within the index itself. For instance, if Apple's share price jumped from $200 to $220 per share, this 10% increase would have a greater effect on the index than if, for example, Expedia’s shares went from $100 to $120 which is a 20% increase.
There are a few main factors to consider when buying or selling options in this index:
The SPX is a weekly options market and the first thing to note is that the index has a large contract size which may be beneficial for large institutional investors or retail traders wishing to trade large amounts of capital. SPX options are approximately 10 times the value of SPY options so this is likely to save considerable brokerage fees when taking up big positions in this market.
SPX options are European style and that means that when they reach expiry they are settled in cash. Furthermore, this settlement can only be exercised at expiration. There are set trading hours for this market which are defined as extended US trading hours. SPX options can offer a tax advantage, especially for longer term investors, as they allow for 60% of trading profits to be treated at a long term tax rate.
You can also purchase options in the S&P 500 ETF (exchange-traded fund) market. It would be extremely inefficient for a fund to buy the corresponding ratio of shares for each of the 500 companies every time an order was placed, not to mention the huge transaction costs involved; so fund managers built a basket of securities which track the S&P 500 index movements near enough tick for tick. There is a little variation since this is market operates like any other and price is determined through an auction.
You may be wondering why is it worth going to all this hassle just to copy the index movements, why not just trade the index itself. The reason is than an ETF can be advantageous for options traders.
One of the main differences with trading the SPY is the fact that its options can be traded on a daily basis which make it much more beneficial for short term speculative trades. The ETF does pay a quarterly dividend, which is highly relevant because traders with in-the-money (ITM) call options will routinely exercise them so that they can collect their dividend.
This makes knowing when your options expire crucial, as you could end up with shares that drop in value before you can liquidate them.
American style options can be exercised at any time after you’ve purchase them, which means if you bought a call option with a strike price of $100, and it is trading at $150 on the stock exchange then you can exercise your option and buy the stock for $100.
SPY options are just 1/10 the size of trading S&P 500 index options which make them more accessible to smaller retail traders. This particular exchange-traded fund generally has much more liquidity than the index proper, which therefore results in tighter spreads (the difference between the bid and the ask prices), however this is not the case with all ETF’s. Aside from the major markets you will likely find that these markets are less liquid, that is to say that the amount of cash which flows through them intraday is less.
Finally, ETF options profits are taxed at the higher short term rate which may or may not be a factor in whether you feel this type of fund serves as suitable investment vehicle for your needs. The taxable event occurs when you liquidate your position, which is liable to a capital gains tax based on the total length of time you held your position. If the position was held for less than one year then the capital gains are taxed at your personal income tax rate.
The second method you can invest in the S&P 500 is to buy into the ETF proper, ie. without using options and the leverage advantage that comes with doing that.
We can invest in the SPDR S&P 500 ETF which means buying actual contracts in the exchange-traded fund for their true value, as opposed to leveraged options. The fact we are buying into the ETF product itself means it as treated as a completely independent security, and as such, varies slightly in it's key points:
Investing in this ETF shares many of the same features as in the options market, although you will notice items such as 'expiry' and 'exercise' information is not included since those details are only associated to options.
The main difference between investing in this ETF proper than buying into it with options is the fact you won't get any leverage advantage, but what you will get, is far better tax efficiency. When investing in ETF's, taxes are only realized once an individual sells their ETF on the market.
Thirdly, you can speculate in an S&P 500 futures market which is know as the E-mini Futures (ES).
Investing in the E-mini S&P 500 Futures Market (ES) In addition to the two S&P 500 markets already discussed, there is another option in which to trade your funds, the E-mini Futures market. This market was introduced by the Chicago Mercantile Exchange in September 1997 when the value of an S&P contract was over $500,000, making it impossible for many individuals to trade. The ES market has certain qualities that be advantageous depending on your trading style:
Aside from a short break between 15:15 and 15:30, and a one hour maintenance period between, 16:00 and 17:00, the E-mini futures markets trades the entire day, Monday through Friday. Contracts are substantially smaller than those in SPX market, which was the reason this market was formed to begin with, to give greater access to smaller traders.
This market trades anywhere between 5-10 times the amount of dollars than the SPY daily, and whilst the SPY is a liquid market, the ES features extremely high liquidity; for large orders this means faster transactions and less slippage.
More advantages for retail traders include the greater leverage that comes with trading a futures market. Trading in an equities market such as SPY is subject to Regulation T margin requirements meaning a 50% deposit must be placed, in the futures market it’s around the 5% - 6% region allowing traders much more opportunity for potential profits (and losses, respectively).
1256 tax treatment means that both realized and unrealized capital gains losses and profits are bundled together, with the length of time the trade was held not a factor. 60% of gains are treated at long term rates and 40% at short term rates making it advantageous for anyone trading multiple times within a year. The last point to note is that futures securities generally have lower commission fees compared to equities.
This concludes the lesson for these 3 different investment products, and indeed the 3 different markets in which to trade the S&P 500. Having in-depth knowledge about these markets will not only help you identify which product best suits your needs, but also really aid you to trade at maximum efficiency and profitability.
I hope you understood everything here, even if you are not planning to invest in the market it’s still good to have an understanding of these products, so I hope I explained it well. Feel free to purchase something on my Amazon Wishlist to say thank you ;)