From Index Investing to Index Options

From Index Investing to Index Options

In my opinion, the most influential “inventions” are tools that save time, money and effort. These advancements are fueled by creativity and a desire for greater efficiencies. Historians highlight the domestication of fire, the wheel, the printing press, paper and penicillin as some of the most consequential breakthroughs in human history. If we focus more specifically on the evolution of capital markets, the introduction of indexes became a watershed for further innovation.

Indexed investing makes a potentially complex process very simple. Market indexes are measurement tools. They are an abstraction in many ways. In the 21^st Century, we take access to relatively cheap, inherently diversified index trackers for granted. The financial media regularly highlights the values for a variety of U.S. equity indexes, including the Nasdaq-100® Index (NDX).

Solve Problems

Prior to the introduction of index funds, all fund vehicles (mutual funds, etc.) were actively managed. Asset managers crunched numbers and courted big money. They allocated to specific companies and areas of the market. Execution costs and turnover were both much higher than what the modern market is accustomed to.

Big picture, the problems were two-fold. These funds had significant overhead, so the fees investors paid to own them were relatively high. Beyond that, the data showed that, over time, the active money managers were underperforming relative to these equity benchmarks (indexes).

These funds often had positively skewed equity returns but high costs and imperfect managers. How could that be improved upon?

Why not create a vehicle designed to passively track the performance of those equity indexes with very low turnover?

In March of 1999, Invesco launched its QQQ Trust. It is “a unit investment trust with an objective to provide investment results that generally correspond to the price and yield performance of the Nasdaq-100 Index.” The QQQ fund now has assets under management of around $258 billion.

Source: YCharts

We take for granted that there’s easy access to the performance of major U.S. (and global) equity benchmarks. Investors of all types have benefited from this type of innovation in the market.

What’s an Index?

Let’s try answering the question with another question.

What makes for a great apple pie?

A great pie requires excellent ingredients. Do you like a mixture of apples (Red Delicious, McIntosh, Granny Smith and Honeycrisp)? You’ll also need some sugar, flour, cinnamon, salt, nutmeg, a crust and ice cream. Come on, who doesn’t want it a la mode?

Let’s imagine there’s ten things that go into the “perfect” apple pie recipe. They are all in different ratios. A little cinnamon can go a long way. There’s clearly going to be more apples than sugar. That’s pretty much how an index is constructed. There’s a recipe.

In the case of the NDX, the recipe evolves slightly as capital markets and money flows change. The index is rebalanced quarterly and reconstituted (additions/deletions) annually. The NDX is a modified, market cap-weighted index designed to measure the performance of the 100 largest Nasdaq-listed non-financial companies.

Using our pie analogy, let’s imagine Pinata apples are like financials. They are excluded from the recipe. No pinata apples in this pie.

Here’s how the different sectors (or recipe components) currently break down (as of April 5, 2024):

Source: Nasdaq

The Information Technology sector is like the fruit in our apple pie. It’s the star of the show. Ironically, Apple Corporation (APPL) is the second largest constituent (7.34%) in the index, surpassed only by Microsoft Corporation (MSFT) with an 8.79% weighting. NVIDIA Corp (NVDA) currently holds the third spot (6.33%). Rounding out the top ten, we include Amazon, Meta, Broadcom, Alphabet (both share classes), Tesla, Broadcom and Costco Wholesale, which is an example of a Consumer Discretionary stock.

Further down the list (in weighting terms), you have companies like Starbucks (SBUX), PayPal (PYPL), the Kraft Heinz Company (KHC), Lululemon (LULU) and Keurig Dr Pepper Inc (KDP). They are like our pie’s cinnamon and sugar. They diversify the flavor profile. These companies infuse accents that accompany the “big tech” macro contours.

However, one key characteristic of indexes is that they’re designed to measure. Indexes are not tradeable instruments like securities (single-name equities), ETFs, etc., because they cannot be “delivered” in the same way as 100 shares of AAPL or QQQ. It would be far too capital-intensive and messy to deliver shares of 100 stocks in the perfect ratio, but index options arguably solved that issue.

The Byproducts of Innovation/Index Options

For the past ~40 years, there have been options available on index products. There are calls and puts that trade actively and afford end users exposure to the price levels of the reference asset – like the NDX. On a notional basis, they have become some of the most influential types of options available.

Like many other products pioneered in the early 80s, index options are cash-settled instruments. So, if held until expiration, an in-the-money (ITM) index option will simply settle to its cash value at expiration. Many market participants prefer cash settlement in part because it may be more capital efficient.

European Styled

There are a couple of other idiosyncratic differences between index and equity options. For example, nearly all index options are European styled. That simply means that index options cannot be exercised or assigned ahead of expiration.

By contrast, all equity (single-name securities and ETF) options are American styled. As a result, those options can be assigned/exercised at any point on or before expiration. Call options that are ITM may be exercised early to capture a dividend payment. In unique situations, a put option might be exercised ahead of expiration for balance sheet reasons (interest payments on short stock position after factoring in potential dividends).

Granular Expiries

Option volumes have grown significantly in recent years. That’s in part due to the demand for more short-dated options. Since 2022, the major U.S. index products have been available with daily expirations. In other words, there are Nasdaq-100 Index Options (NDX) that settle every business day, looking out five weeks. End users wanted the ability to craft very specific exposure and have the flexibility to protect against “known unknowns” like a Federal Reserve meeting, inflation and unemployment data.

Tax Treatment

The last idiosyncratic difference between index options and standard equity/ETF options involves their potential tax treatment. To be clear, this is not investment advice; for a comprehensive understanding, you should consult a tax professional who understands options and their tax implications.

There are potential tax benefits associated with non-equity index options, like NDX Index Options and Nasdaq-100 Micro Index Options (XND). For example, most option positions are held for less than a full year (365 calendar days). As such, they are subject to short­term capital gains where the rate varies but is consistent with your income tax bracket. Securities (including options) held for longer than 365 calendar days will likely fall under the lower (long-term) capital gains category.

However, index options are addressed in Section 1256 of the IRS tax code. Typically, 60% of the gains (or losses) from index options will be taxed at the long-term tax rate (lower), and the other 40% will be taxed at the (higher) short-term rate. Similar index-tracking ETF products may not be extended the same tax status.

(Index options held through December 31 of any calendar year will be marked-to-market based on year-end value and likely be factored into annual tax liability)

Here’s a piece dedicated to the topic of index option taxation to learn more.

Recap

We covered a lot in this piece, so let’s recap and reinforce:

• Indexed investing has become increasingly favored by individuals and institutions over the past few decades.

  • Lower fee structures, long-term outperformance and a wide variety of products benchmarked to major indexes helped advance this trend.

• Indexes are designed to measure the performance of a group of assets, but they are not investable/tradeable.

  • Innovative individuals and companies created tradeable products like mutual funds, ETFs, financial futures and index options to help facilitate the growth in indexed investing.

• Indexes vary but have a specific methodology and their constituency will change over time.

• Index options are designed to give end users exposure to (typically 100 units of) a broad-based index like the NDX.

  • There are some important differences between standard equity options and index options, including styling, settlement, expiries and potential tax treatment.

Discover more about the NDX and NDX Index Options here.

Disclaimer: 

Nasdaq® is a registered trademark of Nasdaq, Inc. The information contained above is provided for informational and educational purposes only, and nothing contained herein should be construed as investment advice, either on behalf of a particular security or an overall investment strategy. Neither Nasdaq, Inc. nor any of its affiliates makes any recommendation to buy or sell any security or any representation about the financial condition of any company. Statements regarding Nasdaq-listed companies or Nasdaq proprietary indexes are not guarantees of future performance. Actual results may differ materially from those expressed or implied. Past performance is not indicative of future results. Investors should undertake their own due diligence and carefully evaluate companies before investing. ADVICE FROM A SECURITIES PROFESSIONAL IS STRONGLY ADVISED.

For the sake of simplicity, the examples included do not take into consideration commissions and other transaction fees, tax considerations, or margin requirements, which are factors that may significantly affect the economic consequences of a given strategy. An investor should review transaction costs, margin requirements and tax considerations with a broker and tax advisor before entering into any options strategy. 

Options involve risk and are not suitable for everyone. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options. Copies may be obtained from your broker, one of the exchanges or The Options Clearing Corporation, One North Wacker Drive, Suite 500, Chicago, IL 60606 or call 1-888-OPTIONS or visit www.888options.com. Any strategies discussed, including examples using actual securities and price data, are strictly for illustrative and education purposes and are not to be construed as an endorsement, recommendation or solicitation to buy or sell securities.

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