Part II · Markets · Chapter 2A

What the S&P 500 is

One index, six products

Before Parts VI to IX describe the dealer's end of the trade, you need to be precise about what is being traded. People say "the S&P 500" as if it were a single object. On a screen it is at least six distinct products: an index level, an exchange-traded fund, a futures family and three different options markets. Each has its own settlement rules, contract size, tax treatment, dealer ecosystem and trading hours. Confusion between them produces a surprising amount of bad retail decision-making, including some of the most expensive mistakes an American retail trader can make.

Part II also covers the layer beneath the product: the market microstructure through which orders actually execute. Between your click in a brokerage app and a printed trade sits a routing decision. It determines who fills you, at what price, on what venue and at what cost. Understanding this layer separates retail traders who lose 50 basis points per round trip to invisible costs from those who lose 5. Together, what to trade and how to execute it set the operational baseline that every later strategy assumes.

This chapter takes apart the S&P 500 and its six tradeable instruments. Chapter 2B follows an order from your broker to the venue that fills it: the National Best Bid and Offer, wholesalers, dark pools and the rules on payment for order flow. Chapter 2C opens the order book, where orders make or take liquidity, and covers the order types you control. Chapter 2D prices execution: the spread, the slippage and the market impact that stand between a paper result and a live one. Chapter 2E explains the four account tiers open to a retail trader and the single most consequential operational choice in American options trading: Section 1256 tax treatment.

1 · The index: a list and a formula

The S&P 500 is a list of approximately 500 large American companies, often called large-cap stocks, chosen by the S&P U.S. Index Committee. Its level, quoted under the ticker SPX, summarizes what those companies' shares are worth. The committee admits a company on five criteria:

• Size: its market capitalization, the share price times the number of shares, must be at least $20.5 billion as of 2025. S&P raises this minimum periodically.
• Domicile: the company must be based in the United States.
• Liquidity: its shares must have a high public float and high turnover, so that they trade often and in size.
• Financial viability: its as-reported earnings must be positive in the most recent quarter and over the trailing year.
• Public float: at least 50% of its shares must be available to the public, as of 2025.

The committee meets quarterly to make additions and deletions, which take effect at rebalances on the third Friday of the rebalance month. Trading volume on those days has historically spiked as index-tracking funds adjust their holdings, because a fund that copies the index must buy every addition and sell every deletion.

Weighting by float

The SPX level is a float-adjusted, market-cap-weighted index. Each company counts in proportion to the market value of its publicly tradeable shares, its public float. The float leaves out insider holdings, government holdings and other restricted shares, because those do not trade. Adding up these values and dividing by a number called the divisor gives the level:

Here $P_{i,t}$ is the price of company $i$ at time $t$, $F_{i,t}$ its number of float shares, and $D_t$ the divisor. The sum on top is the float-adjusted market capitalization of the whole index, in dollars. The divisor turns that dollar total into a level, and S&P updates it continuously.

That last step is general: while the divisor and the float shares stay fixed, the index return is the weighted average of the stocks' returns:

Here $R_i$ is the simple return of stock $i$ over the period (Chapter 1A), and its weight $w_i$ is its share of the index's total float value at the start. The largest companies therefore move the index most.

Why the index return is a weighted average

Write $V_{i,t} = P_{i,t}F_i$ for stock $i$'s float value, with the float shares $F_i$ and the divisor $D$ fixed over the period. By (2A.1), the divisor cancels from the index's growth factor:

$$\frac{\text{SPX}_t}{\text{SPX}_{t-1}} = \frac{\sum_i V_{i,t}}{\sum_j V_{j,t-1}}$$ (2A.3)

Multiply and divide each term on top by $V_{i,t-1}$:

$$\frac{\text{SPX}_t}{\text{SPX}_{t-1}} = \sum_i \frac{V_{i,t-1}}{\sum_j V_{j,t-1}}\cdot\frac{V_{i,t}}{V_{i,t-1}}$$ (2A.4)

The first fraction in the sum is the weight $w_i$, and the second is stock $i$'s growth factor $1 + R_i$. The weights add up to 1, so subtracting 1 from both sides leaves (2A.2).

2 · The divisor

The divisor has one purpose: to keep the index level continuous across structural events that would otherwise create artificial jumps. These are events that change the float-adjusted market capitalization without reflecting any real change in shareholder value:

• Index reconstitution, the committee's additions and deletions.
• Spin-offs, in which a company hands its shareholders the shares of a subsidiary.
• Special dividends that effectively return capital outside the float.
• Other corporate actions of the same kind.

The divisor is the load-bearing piece nobody talks about. Three details about how it behaves are commonly misstated.

Ordinary dividends do not change it

When a constituent pays an ordinary cash dividend, its stock price drops by roughly the dividend on the ex-dividend date, the first day a buyer no longer receives it. The index level drops accordingly, and the divisor stays put. This is why SPX is a price-return index: the drift from dividend payments is built into the published level. Total-return tracking lives in a separate index, SPTR, which accrues the dividends in a dividend index of its own.

In the three-stock index, suppose C pays a $1 dividend. Its price falls from $20 to $19 and its float value by $5,000, so the level falls from 1,000 to 990. The shareholders lost nothing: the $5,000 left the share price and arrived as cash. The price-return index records a 1% fall, while a total-return index would count the cash and record none.

Ordinary splits do not change it either

A 2-for-1 stock split gives each shareholder two shares for every one held and halves the share price. In a float-cap-weighted index the float share count doubles as the price halves, so price times float shares is unchanged and the divisor is unaffected. The price-weighted Dow Industrials are different: that index adds up prices rather than values, so its divisor must change for every split.

In the toy index, a 2-for-1 split leaves A at $50 with 4,000 float shares, still $200,000 of value. A price-weighted index of the same three stocks adds up $100 + 50 + 20 = 170$ dollars of price before the split and 120 after. To stay at the same level, its divisor must shrink by the same factor, $120/170$.

What does change it

Three kinds of event actually move the divisor:

• Committee additions and deletions: an addition increases the divisor, so that the index does not gap up. A deletion decreases it, so that the index does not gap down.
• Spin-offs: the parent's float market capitalization drops on the spin date, so the divisor drops to compensate.
• Special dividends large enough for S&P's methodology to classify them as a return of capital.

In each case, the new divisor is set so that the level is the same just after the event as just before it:

where $V$ is the index's total float value, at unchanged prices, just before and just after the event.

S&P discloses the divisor publicly, a number in the eight-billion range that drifts as the committee makes adjustments, but financial media rarely cite it. Without it, the SPX level would gap visibly every time the committee reconstituted the index or a constituent spun off a subsidiary, and there are dozens of those events a year. That the SPX level you saw yesterday is comparable in real economic terms with the level five years ago is entirely the divisor's job.

The figure takes the toy index through each event in turn, always from its starting state. Watch the divisors: the split moves only the price-weighted twin's, while the addition, the deletion and the spin-off move both.

event price move dividend split

addition deletion spin-off

level: 1,000 → 1,040

divisor: 500 → 500

twin: 1,000 → 1,058.8

twin's divisor: 0.17 → 0.17

A rises 10%. Its float value becomes $220,000, so the level rises 4%, A's 10% times its 40% weight. The twin rises more, because A's $100 is 59% of its 170 dollars of price.

After the event	Price	Float shares	Float value	Weight
A	$110	2,000	$220,000	42.3%
B	$50	4,000	$200,000	38.5%
C	$20	5,000	$100,000	19.2%

3 · One number, six products

Four of the six products are options or futures, which Part IV and Part V teach properly. For now you need three definitions:

• A call option gives its buyer the right, not the obligation, to buy the underlying at a fixed strike price on or before its expiry. A put option gives the right to sell at the strike instead. The buyer pays the seller a premium for that right (Chapter 5A).
• A futures contract is an agreement to buy or sell at a set price on a future date, with only a deposit paid up front (Chapter 4B).
• An exchange-traded fund (ETF) is a fund whose shares trade on an exchange like a stock. SPY is an ETF that tracks the S&P 500.

The same underlying exposure, the level of the S&P 500, is delivered through six different contracts. Each has its own price scaling, settlement convention, tax treatment, trading hours and dealer infrastructure. Confusion between these products is one of the most expensive sources of retail error. The first table gives each contract's terms.

The second table gives how each is taxed, when it trades and why it matters.

A few terms in the tables need unpacking. The multiplier converts a quoted price into dollars per contract. The tick is the smallest step in which the price can move. Settlement is how a contract is closed out at expiry, in cash or by delivering shares. "1256 60/40" refers to Section 1256 of the Internal Revenue Code: gains are taxed as 60% long-term and 40% short-term capital gains, whatever the holding period (Chapter 2E).

Strictly, VIX options track the index's expected volatility rather than its level. The VIX is Cboe's index of the implied volatility of S&P 500 options over the next 30 days (Chapter 9A). It belongs in the table because it is built from SPX options and trades beside them. Cboe is the exchange that lists SPX, XSP and VIX options.

What one contract controls

A contract's notional value is the dollar exposure it controls:

Here $m$ is the multiplier, in dollars per point, and $L$ is the level of what the contract tracks. With SPX at 6,000, a single contract of each product represents:

• One SPX option represents $600,000 of notional exposure to SPX.
• One XSP option represents $60,000, exactly one tenth of that.
• One SPY option represents 100 shares of SPY at roughly $600 each, which is $60,000. SPY is designed to track one tenth of the SPX index level, so 1 SPY option is about 1 XSP option in notional. Operationally, though, the two are very different products.
• One ES futures contract represents $50 per point × 6,000, which is $300,000 of notional.
• One MES futures contract represents $5 per point × 6,000, which is $30,000.
• One VIX option represents $100 × the VIX level, around $1,500 if the VIX is at 15.

The same arithmetic gives the dollar value of one tick. One tick of ES is 0.25 point, or $0.25 \times \$50 = \$12.50$ a contract, and one tick of MES is $1.25. An SPX option quoted in steps of $0.05 moves $0.05 \times \$100 = \$5$ a contract per tick.

4 · Settlement: AM, PM and the special opening quotation

Two SPX options expiring on the same Friday can settle to different prices, because monthly SPX options expire AM while weekly and 0DTE SPX options expire PM. AM settlement uses the special opening quotation (SOQ), a synthetic opening print built from the first reported trade of each constituent stock that morning. PM settlement uses the official 4:00 PM close. Times in this chapter are Eastern Time (ET), the time zone of the New York markets.

The AM-PM gap is small on most days and large on event Fridays. Suppose half a dealer's book is hedged against AM-settled SPX and the other half against PM-settled SPX. The dealer then carries intraday risk that the AM and PM prices differ. That risk is non-trivial on the monthly options expiration (OPEX) Friday, the third Friday of the month. It is one of the reasons OPEX Friday opens can show a sharp, uncorrelated move in the first ten minutes. Dealers are reconciling the SOQ they actually got with the SOQ their books were hedged against.

This mechanic is invisible on retail charts, but it is the canonical reason that "the first thirty minutes of OPEX Friday are weird". If you trade through OPEX morning, knowing why it is weird is the difference between being hit by it and trading around it.

A level that no screen showed

A secondary effect comes from the way the SOQ is built. On a typical day, all 500 components open within a few seconds of 9:30. On a stressed day, with heavy overnight news, large global moves or a circuit breaker scenario, components can stagger their opens over many minutes. The resulting SOQ is a synthetic level that may differ measurably from any SPX value quoted at any given moment. Cash-settled options that reference the SOQ pay or receive cash on that synthetic value, not on the continuous SPX after the open.

Traders running expiration-day strategies who do not understand this can be surprised by a 30-cent or larger discrepancy between the settlement they expected and the one they got.

5 · Cash settlement against physical settlement

SPX, XSP, ES, MES and VIX all settle in cash, while SPY settles in shares. The difference is enormous for any strategy held to expiry.

Cash settlement means an in-the-money option simply credits or debits the cash difference between the strike and the settlement price. No shares are delivered, there is no exercise decision to make, and nothing is left open to gap between expiry and the next morning. You wake up on Monday with cash exactly equal to the in-the-money amount, or no change if the option expired out-of-the-money.

Physical settlement means an in-the-money short option ends with shares changing hands at the strike. Being on the receiving end of an exercise is assignment. What changes hands depends on which side you wrote:

• Short call assigned: you must deliver 100 shares per contract at the strike. If the call was a covered call, because you own the shares, the shares are sold at the strike. If it was a naked call, you end up short the stock at the strike, exposed to overnight upside.
• Short put assigned: you must receive 100 shares per contract at the strike, which means buying them. If the put was cash-secured, your cash converts into stock at the strike. If it was a naked put in a margin account, the long stock consumes buying power.

Either way, you wake up to a position you did not have when you went to sleep, marked at whatever price the market reopens at. The gap between Friday's 4:00 PM mark and Monday's open is yours to absorb. For SPY it is typically small, a fraction of a percent on a normal weekend. On event weekends or during stress, the Monday gap can be 3% to 5% or more. Anyone running SPY short puts with a strike near Friday's close carries a weekend gap risk that was never priced into the trade.

SOQ risk on a cash-settled expiry

Cash settlement removes the Monday gap, but an AM-settled option still carries a morning one. AM-settled contracts, the monthly SPX options on Friday and VIX options on Wednesday, expire to the SOQ built from that morning's first trades. The SOQ can differ materially from the previous day's close, through overnight news and the staggered opening rotation. A short put that was safely out of the money at 4 PM on Thursday can be in the money at Friday's SOQ. Close AM-settled positions on the afternoon before expiry, rather than holding them into the SOQ.

Single stocks

For individual stocks the gap risk is dramatically worse. Single-stock options are not the focus of this book, which touches them only in Part XI. Earnings releases, merger and acquisition announcements and other surprise news can produce gaps of 10% to 20%. Anyone running short puts on individual names is structurally short jump risk. The variance risk premium they collect, the premium option sellers earn for bearing that risk (Chapter 10C), may or may not be enough to compensate.

6 · Why XSP suits a retail account

Put-writing means selling puts, month after month, to collect their premium. For any cash-secured systematic put-writing strategy, XSP is the retail-correct choice. It gives you four things at once:

• Size: the same SPX exposure, scaled to one tenth of the notional, so that the position is sized appropriately in any retail account.
• Tax: the same 1256 60/40 tax treatment as full SPX.
• Settlement: cash settlement, so there is no Monday-gap risk.
• Exercise: European-style exercise, which allows exercise only at expiry, so there is no early assignment.

A SPY option is an American-style option: its holder can exercise it on any day up to expiry, so its seller can be assigned early (Chapter 12H).

Most retail traders use SPY puts because SPY is what they see. It is the most-quoted equity ETF, it is prominently displayed in brokerage apps, and many retail-targeted strategy videos use it as the example. SPY is operationally inferior on every dimension except spread width. There it is slightly tighter: typically $0.01 to $0.02 on at-the-money SPY options, against $0.05 to $0.10 on XSP.

The tax difference alone is large, and Chapter 2E works it through. It is often quoted as approximately 12 to 14 percentage points of tax on every dollar of gain, for a top-bracket American individual taxpayer. Chapter 2E shows that a like-for-like comparison of the two tax rates gives about 10 points. On a strategy that captures 8% a year, the quoted gap is about 100 basis points of after-tax return a year, and the like-for-like gap about 80, turned on or off by instrument choice alone. Over a decade of compounding on a substantial account, that gap is a small house.

7 · Trading hours: ES tells you where SPX opens

Cash SPX trades only during regular trading hours, 9:30 AM to 4:00 PM ET. The futures, ES and MES, trade nearly 24 hours, from Sunday 6:00 PM ET through Friday 5:00 PM ET, with a brief daily maintenance window. SPX options have extended hours on Cboe, from 8:15 PM ET the previous evening through 9:15 AM ET. The cash SPX index, though, does not exist outside regular hours.

When financial media report "S&P futures up 0.4% overnight", that is ES: the cash SPX index simply does not exist between 4:00 PM and 9:30 AM. The opening print of SPX at 9:30 AM is built from the actual opening trades of all 500 components. That is why it sometimes prints away from where futures were trading thirty seconds earlier. Traders watch ES overnight to anticipate the SPX open. The basis between ES and SPX during overnight hours encodes the market's evolving consensus.

Why ES and SPX stay together

A future is tied to its index by the cost of carry, the cost of carrying the index until the future expires. Holding the stocks costs you interest on the money tied up in them and pays you their dividends. The future skips both, so its fair price is the index grown at the interest rate less the dividend yield:

Here $F$ is the fair futures price, $S$ the index level, $r$ the risk-free interest rate, $q$ the index's dividend yield and $T$ the time to the future's expiry, in years. The factor $e^{(r-q)T}$ is continuous compounding at the net rate $r - q$ (Chapter 1A). The basis, $F - S$, shrinks as expiry approaches, and at expiry, where $T$ reaches zero, the future converges on the index. Chapter 4B treats futures in full, including why their price carries the cost of financing.

This structural arbitrage keeps the two locked together during regular hours. If ES trades meaningfully above SPX, adjusted for financing and dividends, arbitrageurs short ES and buy a basket of SPX components. If ES trades meaningfully below SPX, they do the reverse. The trade runs continuously during regular hours and keeps the ES-SPX basis tight. Overnight, nobody can arbitrage directly against a cash SPX that does not exist. The basis can then drift, and it becomes a forward-looking estimate of the open.

8 · Why dealers hedge in ES

Parts VI to IX describe dealer hedging in detail. A dealer who has sold an SPX option must hedge the resulting delta exposure, the option's sensitivity to small moves in the index. The dealer typically does this in ES futures rather than in cash SPX stocks or SPY, for three reasons:

1. ES has tighter spreads at institutional size than SPY.
2. ES trades nearly 24 hours while cash SPX does not, so overnight risk can be hedged.
3. ES margining under SPAN, the futures exchanges' risk-based system, is more capital-efficient than margining SPY shares under Reg-T (Chapter 2E).

When Part VI describes the dealer buying shares to hedge a short call, the literal-share reading is wrong. The dealer is buying ES futures contracts in size, with cash-share hedging used only at the margin to flatten the remaining basis. The flow shows up in the SPX cash market only indirectly, through the arbitrage that links the two. This matters operationally: the highest-frequency intraday momentum effects of dealer hedging (Chapter 6C) show up most clearly in ES prints, not SPY prints. The two are correlated enough that SPY shows them too, slightly delayed.

9 · Check yourself