🎯 In 30 seconds: You can trade options on the whole S&P 500 in three main ways. SPX options are large, European style (exercise only at expiration) and settle in cash. XSP is the same thing at one tenth the size. SPY options are options on an ETF: American style, settled in ETF shares, taxed like stock options. Broad-based index options like SPX and XSP fall under Section 1256 of the tax code: 60% of the gain or loss is treated as long term and 40% as short term, and open positions are marked to market at year end. Standard monthly SPX options settle on Friday's opening prices, which brings a risk you cannot trade out of.
What an index option is
An index is a number, not a thing you can own (see Market indexes). An index option is a bet on that number. When it is exercised, no shares change hands. The option holder simply receives the difference between the index level and the strike, times the multiplier, in cash.
The same strategies from earlier chapters work on index options: vertical spreads, iron condors, protective puts. What changes is the contract's size, how and when it settles, and the tax.
SPX vs XSP vs SPY
For size comparisons, this chapter uses a hypothetical S&P 500 level of 6,000. Check the index dashboard for today's level.
| SPX | XSP (Mini-SPX) | SPY options | |
|---|---|---|---|
| Underlying | S&P 500 Index | S&P 500 Index, 1/10 size | SPDR S&P 500 ETF shares |
| Contract value at 6,000 | 6,000 x $100 = $600,000 | 600 x $100 = $60,000 | About one tenth of the index x 100 shares, near $60,000 |
| Exercise style | European: only at expiration | European: only at expiration | American: any time |
| Settlement | Cash | Cash | 100 ETF shares delivered |
| Early assignment risk | None | None | Yes, including around the ETF's dividends |
| US tax treatment | Section 1256 (60/40), per Cboe | Section 1256 (60/40), per Cboe | Usual short-term or long-term rules |
The SPY row about taxes is the general treatment of options on ETFs. Tax rules depend on your situation, so confirm with a tax professional before relying on the difference.
Cash settlement, worked
Hypothetical example. You buy one XSP 600 call for $8.00, which costs $800. At expiration, the settlement value is 615.
| Intrinsic value: (615 - 600) x $100 | $1,500 |
| Premium paid | -$800 |
| Profit, credited in cash | +$700 |
- Max loss = premium = $800, at or below 600.
- Breakeven = strike + premium = 608.
- Max profit = unlimited in principle.
The identical trade in SPX is ten times larger: buy the 6,000 call for $80.00 ($8,000), settle at 6,150, receive (6,150 - 6,000) x $100 = $15,000 in cash, profit $7,000. That size is why XSP exists. A single SPX contract is far too large for most personal accounts.
With SPY options, the same view would end with shares: exercising a call means buying 100 SPY shares at the strike, which needs the cash or margin to pay for them.
European style: what it does and does not mean
European style means the option can only be exercised at expiration. It does not mean you are stuck. You can still sell or buy back the option at any time while the market is open.
The practical benefit is for sellers. A short SPX or XSP option cannot be assigned early. The early-assignment surprises described in Managing options risk, like a short call assigned the night before an ex-dividend date, do not happen. That is why many spread and condor traders prefer index options.
AM settlement vs PM settlement
The settlement value is the index number used to work out what each option pays. There are two kinds:
- PM-settled: based on the closing prices on expiration day. SPX Weeklys (SPXW), which Cboe now lists for every weekday, are PM-settled, and Cboe lists P.M.-settled XSP expirations.
- AM-settled: based on the opening prices of every stock in the index on expiration morning. The standard monthly SPX options, which expire on the third Friday, work this way. Cboe calls the result the exercise-settlement value, or SET.
With AM settlement, trading in the option stops at the close on the business day before, usually Thursday. The settlement value is then calculated from Friday's opening prices. It can be very different from Thursday's close, and it may not be published until some time after the open, because it waits for every stock in the index to open.
Section 1256 and the 60/40 rule
The tax code treats some contracts differently from stocks. A Section 1256 contract includes a "nonequity option", and IRS Publication 550 lists broad-based stock index options, giving the S&P 500 as its example. Cboe states that SPX and XSP options qualify, while noting that investors should consult a tax advisor. Three rules follow:
- 60/40: 60% of the gain or loss is treated as long term and 40% as short term, no matter how long you held the option. A position held for one day still gets 60% long-term treatment.
- Mark to market: any Section 1256 contract you still hold at the end of the tax year is treated as sold at its fair market value on the last business day of the year. You report that gain or loss for the year, even though you did not sell.
- Form 6781: these gains and losses are reported on IRS Form 6781, then carried to your capital gains schedule. Individuals with a net Section 1256 loss can generally elect to carry it back up to 3 years against earlier Section 1256 gains.
Worked example. You make a $7,000 gain on index options held for a few weeks. Assume, for illustration only, that your short-term rate is 22% and your long-term rate is 15%.
| If it were all short term: $7,000 x 22% | $1,540 |
| 60/40: $4,200 x 15% + $2,800 x 22% | $630 + $616 = $1,246 |
| Difference | $294 less tax |
Year-end example. You buy XSP calls in November for $800. On the last business day of December they are worth $1,500 and you still hold them. You report a $700 gain for that year (60/40). If you sell them in January for $1,300, you report a $200 loss in the new year, because your starting point is now $1,500.
The 60/40 rule helps on gains and is less helpful on losses, since 60% of a loss is long term. And it is not a reason to trade. A tax saving on a profit only matters if there is a profit. See Taxes for traders.
VIX options, briefly
The Cboe Volatility Index (VIX) measures the 30-day implied volatility of the S&P 500, calculated from SPX option prices. VIX options let you trade that number. Things that trip people up:
- You cannot buy the VIX itself. Cboe's VIX FAQ explains that the estimated forward price of the VIX, where it is expected to be at expiration, is a key driver of VIX futures and options prices. So a VIX option can move much less than today's VIX number when expiration is weeks away.
- European style, cash settled. Per Cboe's specifications, they can only be exercised on the expiration date.
- Odd expiration day. They usually expire on a Wednesday. The settlement value is a Special Opening Quotation (SOQ) of VIX calculated from opening SPX option prices that morning.
- VIX spikes and falls fast. A long VIX call can rise sharply in a selloff, then lose most of its value as markets calm. See Volatility indicators.
Choosing between them
- Small account, index view: XSP is sized for you, with SPX's settlement style and tax treatment. Check that its bid-ask spread is reasonable before trading.
- Larger account, spreads and condors: SPX avoids early assignment and usually has a large, active market.
- You want shares, or a covered call on an ETF you own: SPY options deliver shares and work with SPY you already hold.
- Retirement accounts: the tax difference does not apply inside a tax-advantaged account, so the choice comes down to size, settlement and liquidity.
Try it
Look up the current S&P 500 level on the index dashboard. Then, for an expiration about 30 days out, find an at-the-money call on SPX, XSP and SPY. Write in your trading journal: the price of each, the dollar cost of one contract, the bid-ask spread as a percentage of the price, and whether the expiration is AM or PM settled. Then work out the after-tax result of a hypothetical $2,000 gain on each, using the 60/40 rule for SPX and XSP and short-term treatment for SPY, with assumed tax rates you write down.
- How do SPX, XSP and SPY options differ in exercise style and settlement? Answer: SPX and XSP are European style (exercise only at expiration) and settle in cash. SPY options are American style and deliver 100 ETF shares.
- You buy one XSP 600 call for $8.00 and the settlement value is 615. What is your profit, and what was the breakeven? Answer: $700 profit ($1,500 of intrinsic value credited in cash minus the $800 premium). Breakeven was 608.
- Under the 60/40 rule, what is the tax on a $7,000 index option gain if short-term gains are taxed at 22% and long-term at 15%? Answer: $1,246 ($4,200 x 15% + $2,800 x 22%), compared with $1,540 if it were all short-term.
- Why is holding an AM-settled monthly SPX spread into Thursday’s close risky? Answer: Trading stops at Thursday’s close, but the settlement value comes from Friday’s opening prices. An overnight move can land you deep in the loss zone with no chance to react.