S&P 500 Index Options

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S&P 500 Index Options

S&P 500 index options are option contracts in which the underlying value is based on the level of the Standard & Poors 500, a capitalization weighted index of 500 actively traded large cap common stocks in the United States.

The S&P 500® index option contract has an underlying value that is equal to the full value of the level of the S&P 500 index. The S&P 500® index option trades under the symbol of SPX and has a contract multiplier of $100.

The SPX index option is an european style option and may only be exercised on the last business day before expiration.

Mini-sized S&P 500 Index Option Contracts

To meet the needs of retail investors, smaller sized contracts with a reduced notional value are also available and goes by the name of Mini-SPX.The Mini-SPX index option trades under the symbol XSP and its underlying value is scaled down to 1/10th of the S&P 500.The contract multiplier for the Mini-SPX remains the same at $100.

Product Name Symbol Underlying Value Contract Multiplier Exercise Style
S&P 500® Options SPX Full Value of S&P 500 $100
(Full Contract Specs)
European
Mini-SPX Options XSP 1/10th of S&P 500 $100
(Full Contract Specs)
European

How to Trade S&P 500 Index Options

If you are bullish on the S&P 500, you can profit from a rise in its value by buying S&P 500® (SPX) call options. On the other hand, if you believe that the S&P 500 index is poised to fall, then SPX put options should be purchased instead.

The following example depict a scenario where you buy a near-money SPX call option in anticipation of a rise in the level of the S&P 500 index. Note that for simplicity’s sake, transaction costs have not been included in the calculations.

Example: Buy SPX Call Option (A Bullish Strategy)

You observed that the current level of the S&P 500 index is 815.94. The SPX is based on the full value of the underlying S&P 500 index and therefore trades at 815.94. A near-month SPX call option with a nearby strike price of 820 is being priced at $54.40. With a contract multiplier of $100.00, the premium you need to pay to own the call option is thus $5,440.00.

Assuming that by option expiration day, the level of the underlying S&P 500 index has risen by 15% to 938.33 and correspondingly, the SPX is now trading at 938.33 since it is based on the full value of the underlying S&P 500 index. With the SPX now significantly higher than the option strike price, your call option is now in the money. By exercising your call option, you will receive a cash settlement amount that is computed using the following formula:

Cash Settlement Amount = (Difference between Index Settlement Value and the Strike Price) x Contract Multiplier

So you will receive (938.33 – 820.00) x $100 = $11,833.10 from the option exercise. Deducting the initial premium of $5,440.00 you paid to buy the call option, your net profit from the long call strategy will come to $6,393.10.

Profit on Long SPX 820 Call Option When S&P 500 at 938.33
Proceeds from Option Exercise = Cash Settlement Amount
= (Index Settlement Value – Option Strike Price) x Contract Size
= (938.33 – 820.00) x $100
= $11,833.10
Investment = Initial Premium Paid
= $5,440.00
Net Profit = Proceeds from Option Exercise – Investment
= $11,833.10 – $5,440.00
= $6,393.10
Return on Investment = Net Profit / Investment
= 118%

In practice, it is usually not necessary to exercise the index call option to take profit. You can close out the position by selling the SPX call option in the options market. Proceeds from the option sale will also include any remaining time value if there is still some time left before the option expires.

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In the example above, as the option sale is performed on expiration day, there is virtually no time value left. The amount you will receive from the SPX option sale will still be equal to it’s intrinsic value.

Limited Downside Risk

One notable advantage of the long S&P 500® call strategy is that the maximum possible loss is limited and is equal to the amount paid to purchase the SPX call option.

Suppose the S&P 500 index had dropped by 15% instead, pushing the SPX down to 693.55, which is way below the option strike price of 820. Now, in this scenario, it would not make any sense at all to exercise the call option as it will result in additional loss. Fortunately, you are holding an option contract, and not a futures contract, and so you are not obliged to anyway. You can just let the option expire worthless and your total loss will simply be the call option premium of $5,440.00.

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Is the Wilshire 5000 a Better Index Than the S&P 500?

The Wilshire 5000 index has much better coverage than the S&P 500

The S&P 500 is arguably the most commonly used index today. It is certainly a step up from the Dow Jones.

That’s because the Dow is comprised of just 30 companies. These 30 companies are hand-selected to generally correspond to the performance of the U.S. economy. The Dow is also price weighted rather than market-cap weighted. This means that the share price of the 30 securities determines their weight, rather than the actual market cap of the constituents.

The S&P 500 is certainly a step up as far as tracking the overall U.S. stock market relative to the Dow. The S&P 500 selects its constituents by committee (similar to the Dow). The committee looks specifically for companies with market caps in excess of $6 billion, with high trading volume, and that help the index to maintain appropriate sector weighting relative to the U.S. economy, among other factors. As the name suggests, there are currently just over 500 constituents in the S&P 500.

Enter the Wilshire 5000

The Dow covers 30 stocks. The S&P 500 covers just over 500. The Wilshire 5000 covers 3,486 stocks; almost seven times the coverage of the S&P 500.

The Wilshire 5000 includes all U.S. stocks with readily available pricing. Thinly traded stocks are excluded because pricing data is not very accurate for thinly traded securities.

This goes far beyond the reach of the S&P 500 which does not cover stocks with market caps under around $6 billion. There are far more companies with market caps under $6 billion than there are companies with market caps in excess of $6 billion.

There are three versions of the Wilshire 5000 Index:

  • Full market-cap weighting.
  • Float adjusted market cap weighting.
  • Equally weighted.

In both the full market cap and float adjusted market cap weighting schemes, constituents are weighted by their size. In the equally weighted version, each constituent is given an equal weight.

The difference between “full market cap” weighting and “float adjusted market cap” weighting is how market cap is calculated. Float-adjusted market cap is calculated as the total number of shares outstanding not controlled by members of the company multiplied by the share price. Conversely, full market cap is simply the total number of shares multiplied by the share price.

The full market cap weighting of the Wilshire 5000 is used to measure dollar amount changes in the entire U.S. stock market. The float-adjusted market cap is typically a better measure of actual performance. Equally weighted index returns have a strong bias toward small caps.

Wilshire 5000: A better index?

On paper, the Wilshire 5000 is an objectively better index than the S&P 500 (and the Dow 30). That’s because it covers a much greater percentage of the U.S. market. A market cap weighted index of about 3,500 securities is going to be more robust than a market cap weighted index of around 500 securities.

While the Wilshire 5000 index is superior to the S&P 500 and Dow, it is not nearly as possible. If you tell the average individual investor you are indexing your performance against the Wilshire 5000 instead of the S&P 500, they will likely wonder why. Then additional explanation is required.

For better or worse, the industry standard is the S&P 500. The Wilshire 5000 was created in 1974. It is unlikely it will suddenly see a massive uptick in popularity 44 years after its creation. The S&P 500 will very likely always remain the “index of choice” for stock market performance comparisons and as a general gauge of market performance.

Disclosure: I am not long any of the ETFs of indices mentioned in this article.

The Best S&P 500 Index Funds

How to Choose the Best S&P 500 Index Funds for Your Portfolio

The best S&P 500 Index funds are generally those that have the lowest expense ratios. However, in addition to low costs, there is a delicate balance of science and art to indexing that makes only a few mutual funds and ETFs qualify to make our list of the best index funds. Also learn about indexing how to choose the best index funds for your portfolio.

Keeping Costs Low With Index Funds

Keeping investment costs low is the aspect of index fund investing that most investors know to be crucial to producing the best index funds. Essentially, all other things being equal, the index funds with the lowest expense ratios generate the best returns over time. This can also be an advantage of using index funds as opposed to actively managed funds.

For example, if an index fund has an expense ratio of 0.12 but a comparable actively managed fund has an expense ratio of 1.12, the index fund has an immediate 1.00% advantage over the actively managed fund. Because index funds are passively managed (they simply match the holdings of a given index), the costs of managing the fund are dramatically reduced. With no real research required, costs can be kept extremely low, which has a positive impact on returns over time.

Look for Low Index Tracking Error

Now we are getting into the science of indexing. Investment analysts put together indexes (various lists of stocks or bonds) to create benchmarks for the purpose of measuring broad market averages. The best-known indexes are the Dow Jones Industrial Average, the S&P 500 and Nasdaq. Index funds seek to mirror the performance of a particular benchmark index. For example, most large-cap stock funds try to beat the best-fit index for large-cap stocks, the S&P 500.

However, the objective of an S&P 500 Index fund is not to “beat the index” but to match it, which means the fund will attempt to replicate the performance of the index. To do this, put simply, the fund will hold the same stocks found within the S&P 500. Therefore, the best stock index funds will do a good job of matching the list of stocks (holdings) represented in the benchmark index. Stock analysts may call this “low tracking error.”

Weighting Methods With Index Funds

There is more to building an index fund than simply buying the securities represented in the index. To create an index fund, and ensure good performance tracking, the management team and supporting staff will determine how much (the number of shares) of each holding on the list to purchase.

The idea is to match the percentage “weighting” of the index itself. Indexes that rank the holdings so that the larger components are given larger percentage weights are called capitalization-weighted indexes (aka cap-weighted or market cap weighted indexes).

The S&P 500 is an example of a cap-weighted index. Most index funds will mirror the cap-weighted index by buying shares of holdings to make the stocks with the largest capitalization the largest holding by percentage in the index fund. For example, if XYZ Corporation stock has the largest market capitalization, XYZ Corporation stock will represent the largest percentage of the index fund.

Size Matters With Index Fund Investing

In the indexing world, size can matter. An index fund with high assets under management (AUM) is not only an indication of quality but also an advantage, especially when it comes to liquidity in ETFs. By comparison, an index fund with a low amount of assets may find difficulty in keeping the portfolio properly weighted to the index.

Large mutual fund companies, such as The Vanguard Group, Fidelity Investments, and Charles Schwab have large numbers of investors and therefore they have the assets to effectively manage the fund (i.e. buy shares of holdings, provide liquidity to meet the demand for investor withdrawals).

Top 3 Best S&P 500 Index Funds

Now that you know what it takes to make the best index funds, you can select the best S&P 500 Index Funds for your portfolio:

Here are three of the best S&P 500 index funds on the market today:

  • Vanguard 500 Index (VFINX): Vanguard was built upon indexing and is the original in the world of index funds. Forty-five years ago, Vanguard founder, John Bogle, observed that the majority of stock investors were unable to outperform the S&P 500 Index consistently over long periods of time. His idea was to simply match the holdings of the index and keep costs low. Simplicity and frugality are two of the greatest tenets of successful investing and Vanguard has these virtues mastered. Vanguard is also owned by its investors, which places its priorities on providing high-quality, low-cost mutual funds and ETFs, as opposed to a culture of high profits typical of some publicly owned financial institutions.
  • SPDR S&P 500 (SPY): This was the first exchange traded fund listed in the United States (January 1993). Investors use SPY because it offers a wide range of large U.S. companies with a single purchase. This high-volume ETF combines stock from companies with a market capitalization of $5 billion or greater in one diverse portfolio, and trades almost 16 billion shares per day on average.
  • iShares Core S&P 500 (IVV): This fund is a broadly traded ETF that tracks the S&P 500. Investors are usually attracted to IVV because they can get S&P 500 exposure at a low holding cost. This ETF trades on average 850 million shares everyday. IVV combines the largest capitalization U.S. stocks in one portfolio, and focuses on tax efficiency and long-term growth.

Tips for Buying Funds With Low Expenses

If you are fortunate enough to have high balances in your investment accounts, you may qualify for other share classes that have even lower expense ratios than those funds listed here. For example, Vanguard has another share class, called Admiral Shares, that provide lower expense ratios.

Bottom Line

The best S&P 500 index funds are generally those with the lowest expense ratios. However, investors are wise to watch for other qualities, such as assets under management, weighting methods, and tracking error. S&P 500 index funds can make good core holdings in a portfolio but they may not be right for all investors.

Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.

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