In my last post I laid out the basics of index options: how they're structured and a few of their usual -- but not guaranteed -- contract terms. Today's post will explore a pretty common confusion between index-based options and ETF-based options. As you'll see below, they may have similar-sounding names and even similar functions, but you should understand the differences in regards to the terms and conditions of each option contact before diving in. Unlike today's picture, they really aren't twins!

Check your underlying!

You may've also heard of the "Q's" (QQQQ), the "Diamonds" (DIA) or the "Spiders" (SPDRs). These very popular options are all based on ETFs, which themselves are modeled on a given index. For example, QQQQ options have as their underlying the Exchange-Traded Fund QQQQ. The QQQQ trades independently, much like a stock, but it represents 1/40 of the value of the Nasdaq 100 index. You can trade the Q's as ETF shares or options on the Q's, or you can trade the full value options on the NDX, an index option that directly represents the Nasdaq 100 index.

What's the difference, you ask? Expiration dates, settlement and assignment may differ between two options related to the same index. Difference number one is that the QQQQ is an underlying that can actually be bought and sold in the marketplace; the NDX index can not be bought or sold. Because of this index options are settled in cash instead of the underlying shares.  So, if you're assigned on an index-based option cash goes from the seller of the option to the buyer; on an ETF-based option, the seller must deliver the actual shares of that ETF.

The next difference to look out for is European vs American style expiration. Many (but not all) of the ETF options are American or can be exercised early, where as their index counterparts are European and can only be exercised at expiration. This is a very important difference especially if you like to sell options, which means you have no control over the exercise/assignment process.

In the big picture, all these related securities tap into the same action of a given index, just in slightly different ways. Just be sure to review the practices for each contract type before you dive in, to avoid surprises later. Check out CBOE's list of index options and ETF-based options, plus check out the SEC's changes to margin rules involving these securities.Check back soon for the next post: how to put index options to use in your trading and investing.

Regards,

Brian (OG)

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options.