Difference Between an ETF & Index 05-28-2010

Cusick's Corner
Each day we discuss noteworthy action in the index and ETF markets. What's the difference between these two products? An index is simply a benchmark used to track the prices of a basket of stocks. It cannot be bought or sold. The S&P 500 Index is one of the most widely watched. It tracks the price action of 500 names. An exchange-traded fund, on the other hand, is an investment vehicle that holds assets. For example, the S&P Depositary Receipts (SPY) is an ETF that holds the S&P 500 stocks. Today, an investor can buy an SPY share for $109.80 and take ownership in the S&P 500. Whether or not an investment is an index or ETF is important for options traders because if it's an ETF, the options will settle for shares. An index option settles for cash.

The major averages moved lower on mixed economic news and the decline accelerated midday Friday on renewed worries about the European debt situation. Domestic news was in focus early after data showed personal incomes rising .4 percent and in-line with estimates, but personal spending unchanged in May. Economists were looking for a stronger .3 percent increase in spending. Later, the ISM Index for May showed a decline to 59.7 from 63.8 the month before. Economists were looking for the gauge of manufacturing activity to fall to 60. Meanwhile, the University of Michigan Sentiment Index showed a rise to 73.6 in May, which was up from 73.3 earlier in the month and better than the 73.2 reading economists had expected. However, after a 285-point rally Thursday, mixed economic news wasn't enough to lift the Dow Jones Industrial Average in morning trading Friday. Instead, the Dow suffered modest losses early and then the decline accelerated after Fitch cut Spain's credit rating and the euro tumbled back to 1.23 against the dollar on the news. The volatility was felt in the equity market and the industrial average is down 75 points heading into the final hour. The CBOE Volatility Index (.VIX) is up 2 points to 31.68.

Bullish Flow
EBAY is down 46 cents to $21.45 and one of the biggest losers in the Nasdaq 100 Friday. In the options market, a noteworthy trade surfaced in early action after an investor paid 55 cents for October 26 calls and collected $1.01 on October 19 puts, 6500X. The position appears to be a new one because volume exceeds open interest in both contracts. In addition, this "risk-reversal" was tied to 325,000 shares and represents a bullish play on EBAY from now through October. No news on the online auctioneer Friday. The company is due to present at a Sanford C. Bernstein Strategic Decisions Conference on June 3.

Bullish order flow was also seen in King Pharmaceuticals (KG), Allergan (AGN), and Origin Agritech (SEED).

Bearish Flow
Cisco Systems (CSCO) shares lost 46 cents to $23.21 and a noteworthy spread in the networking giant was a July 23 - 20 put spread midday Friday. An investor apparently paid 88 cents for July 23 puts, 11000X, and collected 25 cents for July 20 puts, 11000X. This bearish spread, at a 63-cent net debit, appears to be in anticipation of short-term weakness in shares of Cisco. The potential pay-off (excluding commissions) is $2.37 if shares fall to $20 or less by the July options expiration.

Bearish flow also picked up in ATP Oil and Gas (ATPG), Vivus (VVUS), and McDermott (MDR).

Index Trading
Yesterday, we discussed the CBOE Volatility Index (.VIX) and it's relationship to the actual volatility of the S&P 500 Index (.SPX). Since VIX tracks the expected or "implied" volatility [IV] priced into SPX options, it tends to reflect the action of the SPX and, more specifically, SPX realized or statistical volatility [SV]. Of course, there are times when VIX will increase substantially relative to actual volatility - which happens during times of panic. If VIX is significantly higher than SPX actual volatility, it might be too high. On the other hand, if the volatility index falls substantially below actual volatility, it might be too low. When it is too high, SPX options are expensive. If it's too low, SPX options are probably cheap. The same analysis can be applied to any stock, ETF or index. You can do some searching and screening for names with High and Low IV/SV ratios using the optionsXpress Dragon.