A family office holds a $25 million equity portfolio comprised of a diverse basket of stocks, including 10% allocations in several listed companies that as a group, behave very much like the market as a whole. Concerned that the upside market ascent will not continue into perpetuity, the family seeks a source of returns beyond just stock market advances.
To enhance yield, the family office sells upside calls as well as downside puts on cash-settled index options that expire within one month.
The listing of options on various market indexes has allowed many investors to trade a broad segment of the financial market with one transaction. Investors looking to trade options on market indexes have two choices: physically settled options on exchange-traded funds (“ETFs”) such as the SPDR S&P 500 ETF Trust (SPY) and cash-settled index options, such as the S&P 500 Index (SPX) options. In this example, we will focus on cash-settled SPX options.
The first thing to note about SPX options is that, unlike SPY options, they are based on the calculated value of the S&P 500 Index which cannot be bought or sold like an individual stock or ETF. As a result, SPX options settle in cash based on the level of the index when the options expire. The second thing to note is that SPX options, unlike ETF options, are “European” style contracts that can only be exercised on their expiration date. Moreover, cash-settled index options offer different, and sometimes favorable, tax treatment on any capital gains that might be generated (Please consult with your tax advisor for more information).