I sometimes switch to the SPY and IWM options rather than trading options on the bigger indices on which they're based. Experienced traders will have read many pro-and-con type articles, some of them my own, for trading one or the other. I thought it might be time for an update, especially on behalf of newer traders.
Why do I sometimes switch to the options on the SPY and IWM rather than on my preferred SPX and RUT? Margin requirements, liquidity and the ease of setting contingent orders sometimes prompt those decisions. When I'm testing a new trading approach and am ready to move from back testing and paper trades into live trades, I tend to test the trades in the SPY or IWM first. As of the afternoon of May 13, 2011, a 6-contract SPY iron butterfly centered at 134, with the SPY at 134.20 and with wings six points away from 134, would require $1,347.00 in buying power if bought at the mid price, often possible with the SPY. That includes $60.00 in round-trip commissions (to open and close) of $1.25 a contract. A 6-contract SPX iron butterfly with wings 60 points away would require $14,925.00 in margin, including that same $60.00 for round-trip commissions. Obviously, if I want to test a trading method that requires at least six contracts but am just tentatively stepping into the trade, the SPY allows me to test it without committing the kind of money that the SPX does.
Another pro for the SPY and IWM options concerns liquidity. Although the RUT's options have been highly liquid over the last couple of years, that wasn't always true of the RUT, and they appear to be getting a little more difficult to trade again. These things go in cycles and also depend on market conditions. However, in general, the SPY and IWM options prove a bit more liquid than their bigger counterparts.
That's important to me if I know I'm going to be away from my trading desk for significant portions of the trading month. Having highly liquid vehicles means that I can set contingent orders with at least some confidence that, outside fast-moving market conditions, they're likely to get filled if I set appropriate limit prices. I base my limit prices on the mark or mid-price at the time the trade is triggered, selling a few cents under the mark and buying a few cents over it. The SPY and IWM options offer many advantages for those with small accounts, those who are testing new trading strategies and those who can't always monitor the markets.
I know of an experienced options trader who trades many more than six SPY contracts at a time, tens of times more than six, because he loves their flexibility and liquidity. Other experienced option traders regularly question his choice. Why? One reason that quickly asserts itself is the potential profit versus the commissions paid. If losses might be greater in the big indices, so might potential profit be larger. Remember that my two examples required the same $60.00 for round-trip commissions to enter and exit the trade. However, if I plan on making 15 to 25 percent of the margin withheld for that trade, you can see that my potential profit for the SPY iron butterfly ($202.05 to $336.75) is much smaller than the more lucrative SPX version ($2238.75 to $3731.25). If my SPY butterfly requires a lot of adjustments, and if in fact, it was my purpose to test an adjust-early-and-often procedure, those commissions are soon going to eat up available profit. In fact, the whipsawing markets required so many adjustments of my last month's IWM calendar trade that they and the sinking volatilities for a while made further adjustments a losing game. If the same trade had been placed in the RUT, those commissions wouldn't have taken such a toll.
For this reason and others, after testing is finished or when I have some confidence that I'll be able to attend to trades, I prefer the bigger indices. Those bigger indices get a more preferential tax treatment, too, or at least they did as of 2010. With many changes being discussed in the tax code and treatment of capital gains, I of course don't know if that preferential treatment will continue into the future. As of now, gains from options trades on the broad-based indices are reported on tax form 6781, where they are split 60/40, with 60 percent treated as long-term capital gains with the more preferential rate and 40, as short-term. As of 2010, this was true regardless how long the trade had been open.
Because these index trades are also reported differently than other options and stock trades, it's also easier to fill out the tax returns, without being troubled unduly by wash sale rules. Verify this information with your accountant, but regardless of the way you account for your trades, these options contracts are marked-to-market at the end of the year, and reporting them is as simple as filling out the appropriate tax form with the totals and attaching a copy of your brokerage's transaction list. I would list my old archived articles on this topic, but as I said, changes may be afoot and I don't know what will change by the time someone is preparing next year's returns.
Another reason I prefer the big indices is that we don't have to worry about ex-dividend days. Both the SPY and IWM offer dividends, although it's notoriously difficult to find out just when and how much. The SPY has a nasty habit of having the ex-dividend day during opex week. If, as part of your position involves selling calls and they're enough in the money that there's little extrinsic value left in them when that ex-dividend day arrives during opex week, you're at more risk. You might end up with some short SPY or IWM stock in your account and also have to pay someone dividends on the stock you "sold" them. If you tend to carry your trades into opex week and you've sold SPY, IWM or other ETF calls that are in the money, you need to research the ex-dividend date and decide if you want to alter your position or close it.
These constitute some of the thought processes I got through when deciding on the ETF versus big index question. Experienced traders will have other considerations, too, appropriate to their trades. Even experienced traders sometimes forget about the tax consequences of trading the SPY versus the SPX, for example, so I thought this reminder was due for all.