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Month: January 2022

Implied Volatility Guides (with Visual Examples)

Posted on by Mike Martin

Last updated on March 29th, 2022 , 03:18 pm

falling stock

7 guides to help you master topics related to implied volatility (option prices).

Implied Volatility Basics

Implied volatility represents a stock’s option prices, and is one of the most important options trading concepts to master.

 
Read Guide

What is the VIX Index?

vix chart

The VIX Index is a commonly watched indicator, as it measures option prices on the S&P 500 Index.

 

Read Guide

The Expected Move

The “expected move” represents a probabilistic forecast for a stock’s price in the future.

Read Guide

Trading VIX Options

Want to trade VIX options? Be sure to understand common misconceptions.

Read Guide

Trading VIX Futures

VIX futures can be used to trade expectations related to changes in the VIX Index.

Read Guide

The VIX Term Structure

The VIX term structure represents the relationship between near-term and long-term VIX futures contracts.

Read Guide

IV Rank vs. IV Percentile

How do you know if a stock’s current implied volatility is high or low relative to its historical levels? IV rank and percentile can help.

Read Guide

Mastered implied volatility? Move on to the Greeks next!

 

Option Greeks Home

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Additional Resources

Implied Volatility for Trading Options | tastytrade

Historical and Implied Volatility – The Options Industry Council

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IV Rank vs. IV Percentile: Which is Better?

Posted on by Chris Butler

Last updated on April 14th, 2022 , 09:35 am

IV rank vs IV percentile formulas

When trading options, understanding both IV rank and IV percentile can be very advantageous – but is one metric more beneficial than the other? In this article, projectfinance will stack these two volatility metrics side by side – and declare a winner!

Stocks and Implied Volatility

All stocks in the market have unique personalities in terms of implied volatility (their option prices). For example, one stock might have an implied volatility of 30%, while another has an implied volatility of 50%. Even more, the 30% IV stock might usually trade with 20% IV, in which case 30% is high. On the other hand, the 50% IV stock might usually trade with 75% IV, in which case 50% is low.

So, how do we determine whether a stock’s option prices (IV) are relatively high or low?

The solution is to compare each stock’s IV against its historical IV levels. We can accomplish this by converting a stock’s current IV into a rank or percentile.

 

  • Care to watch the video instead? Check it out below!

Implied Volatility Rank (IV Rank) Explained

Implied volatility rank (IV rank) compares a stock’s current IV to its IV range over a certain time period (typically one year).

Here’s the formula for one-year IV rank:

 

iv rank formula 2

For example, the IV rank for a 20% IV stock with a one-year IV range between 15% and 35% would be:

 

iv rank example

An IV rank of 25% means that the difference between the current IV and the low IV is only 25% of the entire IV range over the past year, which means the current IV is closer to the low end of historical volatility. 

Furthermore, an IV rank of 0% indicates that the current IV is the very bottom of the one-year range, and an IV rank of 100% indicates that the current IV is at the top of the one-year range.

Implied Volatility Percentile (IV Percentile) Explained

Implied volatility percentile (IV percentile) tells you the percentage of days in the past that a stock’s IV was lower than its current IV.

Here’s the formula for calculating a one-year IV percentile:

 

IV percentile formula

As an example, let’s say a stock’s current IV is 35%, and in 180 of the past 252 days, the stock’s IV has been below 35%. In this case, the stock’s 35% implied volatility represents an IV percentile equal to:

 

IV percentile formula example

An IV percentile of 71.42% tells us that the stock’s IV has been below 35% approximately 71% of the time over the past year.

Applications of IV Rank and IV Percentile

Why does it help to know whether a stock’s current implied volatility is relatively high or low? Well, many traders use IV rank or IV percentile as a way to determine appropriate strategies for that stock.

For example, if a stock’s IV rank is 90%, then a trader might look to implement strategies that profit from a decrease in the stock’s implied volatility, as the IV rank of 90% indicates that the stock’s current IV is at the top of its range over the past year (for a one-year IV rank).

On the other hand, if a stock’s IV rank is 0%, then options traders might look to implement strategies that profit from an increase in implied volatility, as the IV rank of 0% indicates the stock’s current implied volatility is at the bottom of its range over the past year.

So, with IV rank and IV percentile at your disposal, which one should you use? Is one better than the other? In the next section, we’ll compare the two metrics visually, and explain why one may be better than the other.

IV Rank vs. IV Percentile: Which is Better?

iv rank vs iv percentile

So, at this point you know about IV rank and IV percentile as a means to gauging a stock’s current vs. historical levels of implied volatility, but which one should you use?

IV Rank Doesn't Tell the Whole Story

Recall that IV rank tells you where a stock’s current implied volatility lies relative to its IV range over a certain period of time, typically a year.

One of the issues with IV rank is that if a stock’s IV surges to an abnormally high level, almost all IV rank readings going forward will be low, even if the stock’s current IV is still relatively high.

As an example, consider the following chart:

If you focus your attention on the very first days in this chart, you’ll notice that the S&P 500 implied volatility was around 22.5%, which translated to an IV rank over 75%. However, later on in the year implied volatility spikes to 40%. In the shaded region on the very right of the graph, you’ll notice that implied volatility rises to 25%, but now IV rank is less than 50%.

When IV falls after a massive surge in implied volatility, IV rank readings will be low even when the implied volatility of the stock price is still relatively high. In this example, the implied volatility of the S&P 500 is below 20% almost the entire year, but after the significant spike in implied volatility, the IV of 25% translates to an IV rank less than 50% later in the year.

Now, let’s look at the same time period, except this time we’ll examine IV percentile:

 

As we can see, even after the spike in implied volatility to 40%, the rise in implied volatility to 25% at the end of the year translated to an IV percentile of 93%, indicating that implied volatility was below 25% in 93% of the days over the past year.

Now, when the implied volatility of the S&P 500 spiked to 40%, what would happen if it stayed at 40% for an extended period of time? Well, IV rank would be pinned at 100%, telling you that the 40% IV is the highest implied volatility the S&P 500 has seen over the past year. However, IV percentile would fall, as the 40% IV becomes more “normal.” So, when a market’s implied volatility personality changes, IV percentile will be the first to let you know.

Final Word

IV Percentile

So, the bottom line is that IV rank or IV percentile can be used to gauge a stock’s level of implied volatility (current level of volatility) relative to its historical levels of implied volatility. However, IV percentile tells you more of the story, and serves as a better “mean-reversion” indicator. Furthermore, IV percentile doesn’t suffer from the flaw of IV rank after an abnormally large increase in implied volatility.

Back to Volatility Guides ➥

IV Rank vs IV Percentile FAQs

IV rank and IV percentile are not the same. Both IV rank and IV percentile examine current levels of implied volatility, but they do so using different metrics. IV rank compares present IV to both high and low volatility levels over the past 252 days; IV percentile tells us the percentage of days over the last year when IV was lower than its present level.

IV rank tells us whether the current implied volatility is high or low in relation to the historic one year volatility of an underlying. 

When the IV percentile for an underlying is high, that implies option premiums will also be elevated. This may be a good time to sell premium using options strategies such as strangles, straddles, vertical spreads (credit spreads) and iron condors. However, if you believe the stock price will experience even higher volatility in the short-term, debit spreads may be more appropriate. 

Additionally, with low IV percentile, traders tend to favor net long positions in options. 

Next Lesson

Additional Resources

CBOE Volatility Index: Live Data

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VIX Term Structure – The Ultimate Guide w/ Visuals

Posted on by Chris Butler

Last updated on March 16th, 2022 , 01:23 pm

The VIX term structure (sometimes called the “VIX futures curve”) is the relationship between the prices of short-term and long-term VIX futures contracts. 

The shape of the VIX futures prices when plotted (upwards, downwards, or flat) indicates whether the market is expecting more or less market volatility in shorter-term or longer-term periods.

Additionally, the shape of the VIX futures curve has implications for the performance of volatility-related products.

The shape of the VIX term structure will fall into one of three categories:

➼ Contango (Upward Sloping): Longer-term VIX futures contracts are more expensive than shorter-term contracts. Contango tends to occur in quiet market periods and is also the most common shape of the VIX futures curve.

➼ Backwardation (Downward Sloping): Longer-term VIX futures contracts are less expensive than shorter-term contracts. Backwardation tends to occur during periods of extreme market volatility.

➼ Flat: Longer-term VIX futures contracts are about the same price as shorter-term contracts.

To understand each of these curves, let’s look at an example of each scenario.

Contango: Upward-Sloping VIX Futures Curve

The following chart demonstrates what an upward-sloping (contango) VIX term structure looks like:

 

VIX Term Structure (VIX Futures Curve) in Contango

Data gathered from the Cboe’s Historical VIX Futures Database

In this example, the VIX Index itself is just above 13 while the August VIX future (approximately 120 days away from settlement) is six points higher at 19. The upward sloping nature of the curve suggests that market participants believe volatility will increase from 13 in the future, which makes sense because the long-term average VIX level is around 20.

In the event that the VIX Index (prices of S&P 500 options) remains around 13, the price of each of these VIX futures contracts will lose value as time passes.

Consequently, any long VIX futures traders will lose money, as well as traders who have on bullish trades in related volatility products (bullish VIX option trades, VXX, UVXY, etc.). On the other hand, traders with short VIX futures contracts or bearish positions in volatility products will are likely to profit (bearish VIX option trades, long XIV or SVXY, etc.).

Backwardation: Downward-Sloping VIX Futures Curve

The following chart demonstrates what a downward-sloping (backwardated) VIX term structure looks like:

 

VIX Term Structure (VIX Futures Curve) in Backwardation

Data gathered from the Cboe’s Historical VIX Futures Database

In this case, the VIX Index is above 27. However, the June VIX futures contract (roughly 150 days until settlement) is four points lower at 23. The downward-sloping nature of the curve suggests that market participants believe volatility will decrease from 27 in the future, which makes sense because the long-term average VIX level is around 20.

In the event that the VIX Index (prices of S&P 500 options) remains around 27, the price of each of these VIX futures contracts will “slide up the curve” as time passes. Consequently, any short VIX futures traders will lose money, as well as traders who have on bearish trades in related volatility products (VIX options, VXX, UVXY, etc.). However, any traders who are long VIX futures or have bullish positions in volatility products are likely to make money.d

Flat VIX Futures Curve

In the final example, we’ll look at a relatively flat VIX term structure from early 2016:

 

Flat VIX Term Structure (VIX Futures Curve)

Data gathered from the Cboe’s Historical VIX Futures Database

In this case, the VIX index is at 20 while the five subsequent VIX futures contracts are near 21. While not exactly equal, this VIX futures curve can be described as flat. When the VIX term structure is flat, long and short volatility trades don’t stand to gain or lose too much money if the VIX remains at its current level of 20. However, this could change quickly if the shape of the curve transitions into steep contango or backwardation.

Additional Resources

1) Cboe Volatility Index (VIX) Futures

2) Settlement Information for VIX Derivatives

3) Real-Time & Historical VIX Term Structure Data

Back to Volatility Guides ➥

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CBOE Volatility Index: Live Data

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Trading VIX Futures | Options Volatility Guide w/ Visuals

Posted on by Chris Butler

Last updated on March 14th, 2022 , 06:35 pm

The Cboe VIX Index measures prices of 30-day option prices (implied volatility) on the S&P 500 Index. Since option prices are an indicator of fear or complacency in the marketplace, the VIX is sometimes viewed as a “fear index” that gauges the level of uncertainty in market participants.

As mentioned in our guide on the VIX Index, the VIX cannot be traded directly, but there are products that allow traders to gain exposure to changes in the VIX Index. VIX futures are one of the products available when trading volatility.

The following visual demonstrates how a future on the VIX can change relative to the VIX Index:

 

VIX Futures vs. VIX Index

As we can see here, the price of the VIX futures contract changes in the same direction as the VIX Index, but not by the same amount in this case (we’ll discuss this in-depth shortly).

VIX Futures Contract Characteristics

Before discussing the most important things to be aware of when trading VIX futures contracts, let’s go over the basic characteristics of each contract.

vix characteristics

Perhaps the most important aspect to be aware of when trading VIX futures is that the contract multiplier is $1,000, which means each point change in the contract is equal to a $1,000 change in value. 

For example, if a trader buys one contract at 15 and sells the contract at 16, the profit on the trade is $1,000. Conversely, if a trader buys a contract at 20 and sells the contract at 15, the loss on the trade is $5,000.

Because of this, VIX futures are very large contracts that should be traded cautiously, especially since the margin requirement to trade one contract can be as low as a few thousand dollars (the margin will vary depending on the brokerage firm and market volatility).

Another vital point to mention is that the minimum tick value of a VX contract is $0.01, which translates to a bid-ask spread of $0.01. With a contract multiplier of $1,000, a $0.01 tick represents $10 in actual profits or losses. So, a trader would lose $10 by purchasing at the ask price and selling at the bid price, or vice versa (assuming a $0.01 bid-ask spread)

Regarding the settlement value, each VIX futures contract will settle to the value of VRO on the Wednesday morning that is 30 calendar days prior to the subsequent standard S&P 500 Index options expiration. The VRO settlement value comes from a VIX-style calculation on that Wednesday morning.

In terms of the contracts available, weekly contracts have recently been created, but the volume and open interest in the weekly contracts are still extremely low, so trading the standard monthly contracts is far superior to the weekly contracts in terms of liquidity.

Lastly, VIX futures contracts are priced based on the supply and demand of the contracts, which is different from the calculated value of the VIX. So, if the VIX changes in one direction, a future on the VIX might not change at all. In fact, it’s possible for the contracts to move in the opposite direction of the VIX Index. However, as settlement approaches, volatility futures will track the VIX Index much more closely.

Things You Need to Know Before Trading VIX Futures

Before trading a VIX futures contract, these are the most important things you need to be aware of:

1) Longer-term contracts typically have more risk in terms of carrying costs.

2) As a VIX future gets closer to its settlement date, the contract’s price will converge to the VIX Index price, as well as become more sensitive to changes in the VIX Index.

Let’s visualize each of these points by looking at some historical VIX futures data.

VIX Futures Carrying Costs (in Contango)

When holding VIX futures contracts, traders are exposed to profits or losses as the contract converges to the VIX Index. 

When the VIX is low, the futures contracts tend to be priced higher than the index (referred to as contango). As time passes, the futures contracts will decay in price towards the VIX Index if the VIX doesn’t increase.

The following visual illustrates the concept of decaying volatility futures contracts as time passes (the dashed lines represent the settlement dates for each respective contract):

VIX Futures Contango Convergence

Data from Cboe’s Historical VIX Futures Data

At the beginning of the period, each product had the following price and potential loss from purchasing the contract:

The values in this table come from the potential loss when buying and holding a VIX futures contract. For example, if a contract is purchased at 15.42 and decreases to 13.10, the loss will be $2,320. If the contract was shorted at 15.42 and the price fell to 13.10, the profit would be $2,320. However, selling volatility futures has significant risk because the VIX tends to rise very quickly when the market falls (as demonstrated in the previous visual).

So, the next time the VIX Index hits new lows, be wary of buying VIX futures to profit from the inevitable implied volatility expansion. If a volatility trader does not correctly time the increase in the VIX when trading VIX futures, the trader may lose substantial sums of money from the price decay of the contracts when the curve is in contango.

VIX Futures Carrying Costs (in Backwardation)

When the VIX is abnormally high, the futures contracts tend to be priced lower than the index (referred to as backwardation). As time passes, the futures contracts will increase in price towards the VIX Index if the VIX doesn’t decrease.

The following visual illustrates the concept of increasing volatility futures contracts as time passes:

VIX Futures Backwardation Convergence

Data from CBOE’s Historical VIX Futures Data

As we can see here, when the VIX Index surges, the prices of VIX futures tend to trade at lower prices than the index because the market doesn’t expect the VIX to stay at such elevated levels for long. In this scenario, carrying costs are transferred to the sellers of VIX futures, as increasing contract prices lead to losses for sellers. As an example, let’s look at the closing prices of each product on October 14th, 2008:

So, with the VIX at 55.13 and the December VIX future at 32.20, the December VIX future could increase by 22.93 if the VIX stays at 55.13 through the December contract’s settlement. For a trader who sells the contract, an increase of 22.93 results in a loss of $22,930. Of course, these values turn into profits for the buyers of each contract.

In summary, when the VIX Index reaches abnormally high levels, the VIX futures will often be cheaper than the index. Before selling a VIX future to profit from the inevitable volatility collapse, understand that incorrect timing of the volatility decrease may lead to significant losses due to the gradual increase in the contract’s price.

Additional Resources

1) Contango and Backwardation Explained

2) VIX Futures and Options Fact Sheet

Back to Volatility Guides ➥

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Here’s How to Trade VIX Options (3 Things to Know)

Posted on by Chris Butler

Last updated on May 3rd, 2022 , 08:26 am

VIX Options

VIX Definition: In the stock market, VIX is the ticker symbol for Chicago Board Options Exchange’s CBOE Volatility Index. This “fear gauge” index measures expected stock market volatility using options (derivatives) on the S&P 500 index.

VIX Option Nuances

In this section, we’ll cover two of the biggest VIX option nuances:

1) VIX options are not priced to the Index because the VIX does not have any tradable shares. Instead, VIX options are priced to the volatility future with the same settlement date.

2) VIX options settle to a Special Opening Quotation (SOQ) under the ticker symbol VRO. VRO is a VIX-style calculation that uses the opening prices of SPX options on the morning of settlement.

Care to watch the video instead? Check it out below!

TAKEAWAYS

 

  • VIX index options are priced to VIX futures.
    |
  • VIX options are settled European style; this means settlement is done in cash and early exercise/assignment is not possible.

  • Long-term VIX options are less sensitive to changes in implied volatility than short-term options.

VIX Options Are Priced to VIX Futures, Not the VIX Index

One of the biggest nuances of options on the VIX is that they are not priced to the VIX Index. Why is this?

The VIX Index can’t be traded directly, so there are no shares that can be traded to keep the VIX option prices in-line with the Index. 

To demonstrate this, we can examine the intrinsic value of deep-in-the-money options on various products:

options intrinsic value

An option must be worth at least the amount of its intrinsic value. Because of this, something is clearly not right between the price of the VIX put and the VIX index.

If we look at the price of the VIX future with the same settlement date as this put option, the intrinsic value problem will no longer exist:

As we can see, the deep-in-the-money January VIX put is priced almost perfectly to the price of the January volatility future. So, don’t be fooled by any potential “mispricings” when examining options on the VIX.

To hammer this point home one last time, we’ll visually compare the prices of the VIX index and the cost of a long synthetic stock position (strike price of synthetic + cost of synthetic) on the VIX. A long synthetic stock position consists of a long call and short put at the same strike price, and in the same expiration. As the name suggests, a synthetic stock position should replicate a position in the underlying shares.

On the VIX, this means the synthetic should track the underlying product price (the VIX) very closely. Let’s take a look at the long synthetic in VIX options compared to the VIX Index:


VIX Options Pricing vs. VIX Index

Clearly, the cost of the long synthetic does not match up well with the price of the index, as it would with standard equity options on non-dividend stocks. However, if we add in the price of the future that corresponds to the options on the VIX, they should track each other almost perfectly:


VIX Option Pricing vs. VIX Futures

Note that any subtle differences between the price of the synthetic stock position and the VIX future can be attributed to using the mid-price of the options in the synthetic and the mid-price of the VIX future.

Why Are VIX Options Priced to VIX Futures?

Options on the VIX are european-style, which means they can’t be exercised until the expiration date. Additionally, they’re cash-settled, as the VIX doesn’t have tradable shares that can be purchased or sold by exercising. So, if you own a 15 call on the VIX and the VIX Index spikes to 30, you can’t exercise your option to buy VIX shares at 15 to sell them at 30. Instead, your P/L is determined by where 30-day implied volatility is expected to be on VIX settlement day, which is represented by the corresponding VIX futures price.

Additionally, VIX options and futures settle to the same number (VRO) at expiration. VRO is a Special Opening Quotation (SOQ) that uses the actual opening prices of SPX options expiring in 30 days in a VIX-style calculation. VRO represents the 30-day implied volatility on the morning of settlement.

A futures contract with no more future/time to settlement must be equal to the spot price (the current market price) of the product that the future represents. So, an implied volatility future at settlement is equal to the actual implied volatility at the time of settlement (the VIX-style calculation at settlement, under the ticker symbol VRO).

VIX Option Settlement Examples

Now that you know the basics of how options on the VIX work, let’s go through some settlement examples.

In the following table, we’ll compare the final settlement value of options on the VIX based on VRO on the day of settlement.

As we can see here, the settlement values of VIX options has nothing to do with the VIX opening price on the morning of settlement. Additionally, VRO is likely to differ from the VIX open because VRO uses the actual opening prices of SPX options on the morning of settlement, as opposed to using the mid-price like the VIX calculation.

Because of this, it may be wise to close profitable VIX option positions on the Tuesday before VIX settlement, as holding through settlement may lead to unfavorable settlement prices.

Additionally, options on the VIX are cash-settled, which means traders with VIX option positions will receive the value of VIX options at expiration, as opposed to shares in the underlying like they would with standard equity options.

For example, if a trader bought the 15 call for $5.00 and the option settled at $8.76, the P/L on the trade would be +$376 per contract: ($8.76 settlement value – $5.00 purchase price) x 100 = +$376.

Short-Term vs. Long-Term VIX Option Sensitivity

When trading VIX options, you might wonder why you don’t just trade the longest-term VIX options to allow more time for your positions to profit.

The answer is that not all VIX options have the same sensitivity to changes in market implied volatility. When examining movements of the VIX Index and futures, you’ll notice that the VIX Index is more responsive to market movements compared to VIX futures with more time until settlement.

As a result, longer-term options on the VIX are less sensitive to changes in implied volatility.

Consider the following visualization of three different VIX futures contracts in 2008:

 

VIX Futures Sensitivity

Between September 2nd and October 10th, the following movements occurred in each volatility product:

vix expirations

Let’s compare the changes in the call options with strike prices of 20 over the same period:

 

VIX Futures Sensitivity

As we can see, when the VIX increased from 20 to 70, the October 20 VIX call increased from $3.90 to $35.00, while the December 20 VIX call only increased from $4.20 to $14.10.

While trading long-term options on the VIX might give you more time to be right, volatility will need to experience much more significant changes for your positions to profit.

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VIX Options FAQs

The VIX index draws from both call and put options with more than 23 days and less than 37 days to expiration. 

The best way to directly bet against the VIX is to use bearish options trading strategies on the VIX itself, such as the bear call spread and bull put spread. 

Additionally, investors can purchase SVXY, ProShares Short VIX Short-Term Futures ETF. Because of contango, this ETF tends to shed value faster than the VIX. 

Next Lesson

Additional Resources

CBOE Volatility Index: Live Data

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Expected Move Explained: Options Trading

Posted on by Chris Butler

Last updated on September 4th, 2024 , 12:43 pm

Expected Move Definition: The “expected move” of a security represents the amount that a stock is expected to either rise or fall from its current market price based on its current level of implied volatility. This number is very helpful when trading options on both stocks and ETFs.

A stock’s “expected move” represents the one standard deviation expected range for a stock’s price in the future. 

A one standard deviation range encompasses 68% of the expected outcomes, so a stock’s expected move is the magnitude of that stock’s future price movements with 68% certainty.

There are three variables that go into the expected move formula:

1) The current stock price

2) The stock’s implied volatility

3) The desired expected move period (expressed as the number of days)

Since a stock can have multiple implied volatilities depending on the expiration cycle, it’s important to use the implied volatility of the options in the expiration cycle closest to the desired time period. For example, when looking at the option chain on a stock, you might see something similar to the following:

options expected move

If you wanted to calculate the expected move for this stock over the next 75 days, it wouldn’t make sense to use the 7-day implied volatility.

Instead, it would be better to use the implied volatility of the 70-day options. Why? Because the 7-day implied volatility is 27.50% while the 70-day implied volatility is 24.50%. If you used 27.50% for a 70-day expected move calculation, the result would be overstated.

Expected Move Formula

Now that you know some of the best practices, it’s time to perform some calculations. Here is the expected move formula:

 

Expected move formula

If you wish to use trading days instead of calendar days, just change the denominator from 365 to 252, since there are 252 trading days in a year. Both calculations will result in virtually the same number.

Using the formula and table from above, let’s calculate the expected move for each time period. Let’s assume the current stock price is $200:

Expected Move Example (stock at $200)

expected move table 2

The expected moves in this table suggest the following:

➜  The 7-day option prices are implying a 68% probability that the stock price is ±$7.62 from $200 in seven days (between $192.38 and $207.62).

➜  The 35-day option prices are implying a 68% probability that the stock price is ±$15.64 from $200 in 35 days (between $184.36 and $215.64).

➜  The 70-day option prices are implying a 68% probability that the stock price is ±$21.46 from $200 in 70 days (between $178.54 and $221.46).

➜  The 126-day option prices are implying a 68% probability the stock price is ±$30.55 from $200 in 126 days (between $169.45 and $230.55).

The following chart serves as a visualization for the table above:

expected move chart

Calculating the Expected Move With Straddles

This calculation involves taking 85% of the value of the front-month at-the-money (ATM) straddle. The resulting figure is a good ballpark number to determine a stocks expected move. 

Why does this matter to you as an options trader? Knowing how much a stock’s price is expected to fluctuate over various time periods can give you a reasonable expectation for a stock’s future prices. Additionally, if you want to calculate a stock’s expected range over a specific period of time, you have the ability to do so.

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Expected Move FAQs

The expected move tells us how much a stock, ETF or index is forecasted to either rise or fall from its current price. The expected move is derived from calculations involving implied volatility and front month option value. 

The expected move can be calculated simply by multiplying the front month straddle by 85%. This straddle must be comprised of at-the-money options. 

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What is the VIX Index? Volatility For Beginners

Posted on by Chris Butler

Last updated on February 10th, 2022 , 06:38 pm

The CBOE VIX Index is an index that tracks the 30-day implied volatility of the options on the S&P 500 Index. Since option prices are an indicator of fear or complacency in the marketplace, the VIX is sometimes viewed as a “fear index” that gauges the level of uncertainty in market participants.

The VIX can also be used to make decisions regarding option strategy selection. For example, some traders prefer to implement short option strategies when the VIX is high because it is an indication that option prices are more expensive, and therefore there’s more profit potential from the selling side.

Conversely, when the VIX is at very low levels, it is an indication that option prices are cheaper, in which case some traders prefer to implement option buying strategies because there’s less loss potential compared to buying options when implied volatility is high.

In regards to trading the VIX, the index cannot be traded directly. However, traders can gain exposure to movements in the VIX by trading VIX options, futures, and other products related to performance in the VIX.

Historical VIX Index Movements

To better understand the VIX, let’s walk through some visualizations that demonstrate its movements, as well as how it tends to change relative to the overall market (the S&P 500). Here’s a chart of the VIX Index closing prices from November 2015 to November 2016:

 

CBOE VIX Index Graph

As you can see here, the VIX over this one-year period closed between 11.34 and 28.14. But what does the actual VIX number mean? 

The VIX number itself represents the one standard deviation expected range (in percentage terms) for the S&P 500 over the next year.

For example, if the VIX is at 20, that represents a 20% one standard deviation expected range for the S&P 500 over the next year. As a recap, a one standard deviation range encompasses approximately 68% of the expected stock prices in the future.

The following demonstrates how the VIX index level translates to various expected ranges for the S&P 500 (SPX):

VIX table options

Let’s walk through what each of these scenarios represents in terms of probabilities:

With the S&P 500 at $1,500  ➜  A VIX of 10 implies a 68% probability that the S&P 500 will be between $1,350 and $1,650 (±10%) in one year.

With the S&P 500 at $2,000  ➜  A VIX of 30 implies a 68% probability that the S&P 500 will be between $1,400 and $2,600 (±30%) in one year.

With the S&P 500 at $2,000  ➜  A VIX of 50 implies a 68% probability that the S&P 500 will be between $1,000 and $3,000 (±50%) in one year.

For other specific levels, the following formula can be applied:

 

VIX expected range formula

As demonstrated in the table above, a higher VIX indicates that the 30-day S&P 500 options are pricing in a larger expected range for the S&P 500 in the future. Furthermore, a larger expected range indicates more market uncertainty. So, when the VIX is trading at lower levels, the market is more complacent because the options are pricing in less significant price swings.

Conversely, when S&P 500 options surge in price, the VIX spikes to higher levels, indicating that market participants are more fearful because the option prices indicate greater expected price swings.

VIX Index vs. the S&P 500

At this point, you understand the basics of what the VIX Index represents. Next, we’ll discuss the general relationship between the VIX and the S&P 500.

Historically, market participants have become much more fearful when the stock market falls in value because most people own stocks. Conversely, when the stock market is bullish, market participants are calm and complacent. Since investors tend to buy a lot more options when they are fearful, the VIX tends to rise when the stock market falls, and fall when the stock market rallies.

The following chart analyzes the relationship between the closing prices of the S&P 500 and the VIX over the period of November 2015 to November 2016. Additionally, it demonstrates how a change in the VIX translates to a change in the future expected range for the S&P 500:

 

CBOE VIX Index vs. S&P 500 Expected Range

As we can see here, the S&P 500 falls from $2,100 to $1,900 in shaded region A. Over the same period, the VIX rises from 15 to 28. In shaded region B, the S&P 500 rises from $1,850 to $2,075. Over that same period, the VIX falls from 28 to 14.

On the lowest subplot, we can see that an increase in the VIX from 15 to 28 (shaded region A) results in the 1-year expected range increasing from ±300 to nearly ±550, which is a massive increase in the market’s expected movement! On the other hand, we can see that a collapse in the VIX from 28 to 14 results in the 1-year expected range falling from nearly ±550 to ±300.

The previous chart demonstrates that the VIX and the S&P 500 have a very clear inverse relationship. To find out how clear, we visualized the one-month correlation between the VIX Index and SPX from December 2015 to November 2016:

 

VIX and SPX Correlation
 

Historical CBOE VIX Index Levels

In this section, we’ll take a brief look at historical VIX levels. The following chart visualizes the highest, average, and lowest, closing VIX levels since 1990:

 

VIX Index Levels Since 1990

As illustrated here, the VIX is below 20 most of the time. In fact, 61% of the VIX closes have been below 20 since 1990. However, when the VIX does rise, it tends to do so very quickly.

Another important point worth mentioning is that the VIX Index is often said to be “mean-reverting,” which means that when the VIX surges to significantly high levels (above 25 or 30), or falls to low levels (below 15), it will eventually return to a more “normal” level. The mean-reversion of the VIX Index can be explained by the ebbs and flows of fear and complacency in the marketplace.

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CBOE Volatility Index: Live Data

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Implied Volatility Explained (Options Guide w/ Visuals)

Posted on by Chris Butler

Last updated on February 10th, 2022 , 06:40 pm

Implied volatility is the expected magnitude of a stock’s future price changes, as implied by the stock’s option prices. Implied volatility is represented as an annualized percentage.

Consider the following stocks and their respective option prices (options with 37 days to expiration):

implied volatility options table

As we can see, both stocks are nearly the same price. However, the same options on each stock have different prices. In the case of UNP, the call and put prices are much higher than PEP’s options, which translates to an implied volatility that is higher than PEP. So, instead of looking at option prices all day long, options traders use implied volatility to quickly compare the expected price movements (and therefore, the option prices) of various stocks.

Conceptualizing Implied Volatility

When market participants trade options, they typically do it for one of two reasons:

1) To speculate on movements in the stock price or the stock’s option prices (implied volatility).

2) To hedge the risk of an existing position against changes in the stock price.

If market participants are willing to pay a high price for options, then that implies they are expecting significant movements in the stock price or implied volatility. 

Conversely, if market participants aren’t willing to pay much for options, then that implies the market is not expecting significant stock price movements.

Since implied volatility represents the overall level of a stock’s option prices, implied volatility is just a way to describe the market’s expectations for future stock price movements.

Alright, you’ve learned the basics! In the next sections, you’ll learn about what implied volatility represents in terms of probabilities.

Implied Volatility and Probabilities

As mentioned before, implied volatility represents the expected range for a stock’s price over a one year period, based on the current option prices.

More specifically, implied volatility represents the one standard deviation expected price range.

In statistics, a one standard deviation range accounts for approximately 68% of outcomes. As it relates to stock price changes, an ‘outcome’ is the stock’s price at some point in the future.

To calculate the one standard deviation expected range for a stock’s price after one year, the following formula can be applied:

Let’s use this formula to calculate the expected ranges for a few different stocks:

implied volatility 2

Clearly, stocks that have higher IV (higher option prices relative to the stock price and time to expiration) are expected to have much more significant price swings, and vice versa. As a result, higher IV stocks are perceived to be much riskier (and also potentially more rewarding).

To hammer this point home, let’s go through some visualizations of expected ranges.

Visualizing Expected Stock Price Ranges

To demonstrate what an expected range looks like, consider a stock that’s trading for $100 with an IV of 25%:

implied volatility visual

Based on this graphic, we can see that there’s an implied 68% probability that this stock trades between $75 and $125 in a year’s time. Now, this doesn’t mean that the stock won’t trade beyond $125 or below $75, but it does show that the market is pricing in a low probability of such movements.

To take things a step further, multiplying the expected range by two will give us the two standard deviation range:

implied volatility standard deviation

As you can see, a two standard deviation range encompasses 95% of the expected outcomes. Inversely, this suggests there’s only a 5% chance that the stock will be trading below $50 or above $150 in a year.

If we go one step further and multiply the expected range by three, we get a three standard deviation range. In statistics, three standard deviations encompasses 99.7% of the expected outcomes. It is very rare for a stock to experience a three standard deviation move. But, it can (and does) happen!

Next, we’ll visualize the difference between two stocks with different implied volatilities.

High IV vs. Low IV: Expected Stock Price Ranges

To compare two stocks trading at different implied volatilities, we’ll look at two hypothetical stocks trading for $100. Let’s say one stock has an IV of 10%, and the other stock has an IV of 25%. In the following visual, compare each stock’s implied probability distribution:

 

Expected stock price range in high and low implied volatility.

What this visual demonstrates is that low IV stocks are not expected to experience large movements, whereas high IV stocks are expected to experience much larger price fluctuations. More specifically, the implied probability of the 10% IV stock trading below $70 or above $130 in a year is essentially 0%. However, the 25% IV stock has a much higher implied probability of trading below $70 or above $130 in a year.

If we examined out-of-the-money options with the same strike price on each stock, we would find that the 25% IV stock’s options are more expensive than the options on the 10% IV stock.

For example, the 70 put or 130 call would be nearly worthless on the 10% IV stock because the implied probability of the stock trading to those strike prices is almost 0%. However, if we looked at the 70 put or 130 call on the 25% IV stock, we’d find that the options have some value because the stock price has a much wider range of expected prices compared to the 10% IV stock.

Calculating a Stock's Expected Move Over Any Time Period

For one year expected moves, simply multiplying the stock price by implied volatility will do. However, for shorter time frames, the expected range calculation must be adjusted. Here is the formula for calculating a stock’s one standard deviation move for any time period:

 

Expected move formula

Note: you can also use trading days to expiration, but you’ll have to change the denominator from 365 to 252, as there are 252 trading days in a year.

On a $250 stock with 15% implied volatility, the 30-day one standard deviation move would be:

 

Expected range calculation.

If we wanted a one-day calculation, we can adjust the formula accordingly:

 

Expected range formula.

One thing to note about using this formula is that you should use the implied volatility of the expiration cycle closest to your target time period.

For example, if you’re calculating a 5-day expected move, use the IV of the expiration cycle closest to 5 days to expiration. If you’re calculating a 180-day expected move, use the IV of a cycle with close to 180 days to expiration.

Why? Because you want to use the implied volatility of the options that match your target time frame. If you use 180-day option prices (implied volatility) for a 3-day expected move calculation, the expected move result will not be accurate.

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Using Options to Estimate a Stock’s Expected Move – luckbox 

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Options Trading Explained | Visuals for Beginners

Posted on by Mike Martin

Last updated on April 21st, 2022 , 01:55 pm

Calls vs Puts: Options Trading

Ever wondered what stock options are, and what the benefits of trading options are as opposed to simply trading stock?

Keep reading to learn options trading basics and why people trade them. You’ll learn each concept with visualizations to help you understand options logically.

        TAKEAWAYS

 

  • Options are leveraged securities, which means profits and losses are magnified.

  • Options typically have less principle risk than stocks.

  • Options can be combined to profit from any market direction, including markets that go nowhere.

  • All options have a 1.) Strike Price 2.) Expiration Date and 3.) Contract Multiplier (typically 100×1)

  • Call options profit in bullish, or rising markets.

  • Put options profit in bearish, or falling markets.

  • Just like stocks, options can be both bought and sold.

What is Options Trading?

Options trading is the act of buying/selling a stock’s option contracts in an attempt to profit from the stock’s future price movements. Traders can use options to profit from:

1.) Stock price increases (bullish trades)

2.) Stock price decreases (bearish trades)

3.) When a stock’s price remains in a specific range over time (neutral trades).

Option Trading Benefits

The benefits of option’s trading are innumerable. Here are a few of the more important benefits.

  • Leverage

With options, traders can leverage return potential, which means significant gains can be made with relatively small amounts of money.

For example, an options trader can risk $500 and make $500 (100% return on investment) if their stock price prediction is correct. When buying shares of stock, the stock price must increase 100% for you to double your investment.

However, there’s also the potential to lose more money compared to trading shares of stock. Leverage can work for or against you, but when used carefully it can increase returns on investment immensely.

  • Reduce Risk

Another huge benefit of trading options is that the strategies used can sometimes have significantly less loss potential compared to buying/shorting shares of stock. This does not apply to all option’s strategies, but certain strategies do indeed reduce risk when compared to stock trading. 

  • Custom-Tailored

As mentioned earlier, options can be used to profit from virtually any stock price movement (or lack of) in the future. They can even profit when the stock does not move at all!

Unique Option Characteristics

Before getting to the specific details related to options, we need to first cover the 3 unique characteristics of option contracts:

1.) Expiration Date

All options have expiration dates, which is the date the option’s final value is determined and can no longer be traded.

Stocks typically have options with expiration dates ranging from a few days to two years away.

Longer-term option’s are referred to as “long-term anticipation securities”s or simply LEAPs. 

2.) Strike Price

An option’s strike price is the price at which shares will be bought/sold if an option is exercised. We’ll talk more about this in a moment.

3.) Contract Multiplier

The number of shares an option contract can be converted into. Typically, equity options like AAPL options have a contract multiplier of 100 (each option can be converted into 100 shares of stock). Index options are NOT settled via delivery of stock, but cash. 

Options and Leverage (Trade Example)

Our first trade example will demonstrate how options can leverage returns compared to simply buying shares of stock.

Trade Example: Stock Trade vs. Option Trade

Stock Trade  ➜  Buy 4 Shares for $150. Sell 30 Days Later for $160.
Profit  ➜  +$40 (6.7% Return: $40 Profit / $600 Investment).

Option Trade  ➜  Buy the 30-Day 150 Call for $5. Sell for $10 in 30 Days (Stock at $160).
Profit  ➜  +$500 (100% Return: $500 Profit / $500 Investment).

As we can see, the option trade resulted in a much more significant return relative to the money invested. However, if the stock price remained at $150 over the 30-day period, the stock trader would not have lost any money, while the options trader would have lost the entire $500 investment.

If you’re wondering, buying a $5 option costs $500 because of the option contract multiplier of 100. The $5 option price is on a per-share basis, which means the actual cost of the option is 100x more than the option’s displayed price.

The Two Option Types

Now that you’ve seen the power of options, let’s get into the two option types.

The first option type is a call option:

Call Option: This type of option gives buyers the right to buy 100 shares of stock (per contract) at the option’s strike price before the option expires. Here are some examples of what this means:

Strike Price Meaning

$100

Call buyer has the right to buy 100 shares of stock for $100/share before the option expires.

$120

Call buyer has the right to buy 100 shares of stock for $120/share before the option expires.

Since there’s more value in having the ability to buy shares of stock at lower prices, call options with lower strike prices cost more money:

Strike Price Hypothetical Option Price

$100

$3.50

$120

$0.06

Additionally, call options at lower strike prices have a higher probability of being valuable at expiration, as call options only have value at expiration if the stock price is above the call’s strike price at the time of the expiration date.

Call Option Example

To make sure call options make complete sense to you, let’s look at a hypothetical trade example to demonstrate the profit/loss potential when buying a call option.

Call Trade Example

Stock Price  ➜  $50

Trader’s Prediction  ➜  Share price will increase to $60 in two months.

Option Trade  ➜  Buy the 50 call that expires in 60 days for $5.00.

Stock Price in 60 Days P/L of Call Option P/L (+100 Shares)

$0

-$500 (Call Worthless)

-$5,000

$50

-$500 (Call Worthless)

$0 (Call Worth $5)

$55

$0 (Call Worth $5)

+$500

$60

+$500 (Call Worth $10)

+$1,000

$65

+$1,000 (Call Worth $15)

+$1,500

At $50 or less (at or below the call’s strike price), the option will be worthless at expiration because there’s no value in being able to buy shares of stock at $50 with the call option when the stock price is at or below $50.

At $55, the call option is worth $5 at expiration because the ability to buy shares of stock $5 below the current share price is worth $5/share.

At $60, the call option is worth $10 at expiration because the ability to buy shares of stock $10 below the current share price is worth $10/share.

At $65, the call option is worth $15 at expiration because the ability to buy shares of stock $15 below the current share price is worth $15/share.

Compared to buying shares of stock, buying call options can have significantly less loss potential when the stock price falls substantially. However, for the call option to break even or profit, the stock price must increase.

Selling Call Options

Just like shares of stock, call options can also be sold as an opening trade. For instance, let’s say a stock is trading for $100 and we sell the 110 call for $5.00:

Selling Calls

When selling call options, as long as the stock price is below the call’s strike price at expiration the position will be profitable. However, if the stock price rises substantially, the loss potential on a short call position is theoretically unlimited.

Here’s how this particular short call position would perform based on various stock prices at expiration:

For instance, if the stock price rose to $200 by the call’s expiration date, the loss would be $8,500 per call that was sold.

With the stock at $200, the 110 call would be worth $90 because the ability to buy shares $90 below the current share price is worth $90/share. Since the call was sold for $5, the loss would be $85 on the option, which represents an $8,500 loss per contract due to the option contract multiplier of 100.

At $115, the call would be worth $5 and there would be no profits or losses.

At $110 or lower, the 110 call would expire worthless and the call seller would keep the $500 collected when initially selling the call.

Because of the risk outlined above, it’s not advised to sell call options without protection in the form of long stock or another call option purchased against the short call.

The Second Option Type: Puts

Put Options give buyers the right to sell 100 shares of stock (per contract) at the option’s strike price before the option expires. Here are some examples of what this means:

Strike Price Meaning

$80

Put buyer has the right to sell 100 shares of stock for $80/share before the option expires.

$90

Put buyer has the right to sell 100 shares of stock for $90/share before the option expires.

Since there’s more value in having the ability to sell shares of stock at higher prices, put options with higher strike prices cost more money:

Strike Price Hypothetical Option Price

$80

$0.49

$90

$3.50

Additionally, put options at higher strike prices have a higher probability of being valuable at expiration, as put options only have value at expiration if the stock price is below the put’s strike price at the time of the expiration date.

Like we did with calls, let’s go through a hypothetical put option trade example:

 

Trade Example: Put Option

Stock Price  ➜ $200
Trader’s Prediction  ➜  Share price will fall to $190 sometime over the next 30 days.
Option Trade  ➜  Buy the 30-Day 200 Put for $6.50

Stock Price in 30 Days P/L of Put Option P/L (-100 Shares)

$250

-$650 (Put Worthless)

-$5,000

$200

-$650 (Put Worthless)

$0 

$195

-$150 (Put Worth $5)

+$500

$190

+$350 (Put Worth $10)

+$1,000

$175

$1,850 (Put Worth $25)

+$2,500

At $200 or higher (at or above the put’s strike price), the option will be worthless at expiration because there’s no value in being able to sell shares of stock at $200 with the put option when the stock price is at or above $200.

At $195, the put option is worth $5 at expiration because the ability to sell shares of stock $5 above the current share price is worth $5/share.

At $190, the put option is worth $10 at expiration because the ability to sell shares of stock $10 above the current share price is worth $10/share.

At $175, the put option is worth $25 at expiration because the ability to sell shares of stock $25 above the current share price is worth $25/share.

Compared to shorting shares of stock, buying put options can have significantly less loss potential when the stock price increases substantially. However, for the put option to break even or profit, the stock price must fall.

Selling Put Options

Just like calls, put options can also be sold. For instance, here’s how selling a put would work out if we sold a 170 put for $7 on a stock that was trading for $190:

Selling Puts

As long as the stock price is above the put’s strike price at expiration, the position will realize a full profit and 100% of the option premium collected when selling the put will be kept. The reason for that is the put will be worthless because there’s no value in the ability to sell shares at a price below the current share price.

However, if the share price falls, selling put options can result in significant loss potential:

Selling Puts

For example, if the stock price fell to $150 by expiration, the 170 put would be worth $20 because there’s a $20-per-share value in being able to sell shares $20 above the current stock price.

Since the put was sold for $7, an increase to $20 would represent a $1,300 loss per put contract that was sold. The worst-case scenario when selling puts is that the stock price falls to $0 (the company goes out of business) before the option expires.

Final Word

Trading options has its benefits over trading shares of stock, but, as you’ve learned, there are also some massive risks related to trading options. Hopefully, you’ve learned the basics of how options work and are prepared to keep learning.

Want to go in-depth on options trading? Read our complete guide here!

NOTE! In order to trade options, you must first be approved for options trading by your broker. 

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Additional Resources

Options Trading Explained: A Beginner’s Guide – CNBC

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Option ​Order Types: Market, Limit, GTC, Stop-Loss

Posted on by Chris Butler

Last updated on February 18th, 2022 , 08:34 am

TAKEAWAYS

  • Market orders can be filled at any price, and are best avoided while trading options.
  • Limit orders are best practice in options trading. These orders guarantee your fill price, or better.
  • GTC (good-til-cancelled) orders stay working in your account indefinitely.
  • Stop-loss orders are best avoided in options trading, as these order types trigger market orders.

Option Order Types

When entering or exiting a trade, there are many order types you can use. Keep in mind that while we use shares of stock in most of the examples, the same concepts apply to options. However, when compared to options trading, the fills can be vastly different. 

The primary order types are market orders, limit orders, good-til-canceled orders, and stop-loss orders. The following graphic explains the differences between each order type:

Order Types

Of these order types, market orders should be avoided as much as possible. The only exception to this rule is if you absolutely have to get out of a position immediately. However, using limit orders at the bid or ask price is still preferable to using market orders when exiting positions in a hurry.

Due to the predictability of fill prices and the potential for price improvements, the limit order is the recommended order type to use 95% of the time.

To fully understand how each of these order types works, let’s walk through some examples.

Market Order Example

Let’s examine these order types with hypothetical trade examples.

First, let’s look at how a market order might be treated on an option with a bidding price of $4.50 and an asking price of $5.50:

Market Order

Market orders need to be filled immediately, and the easiest places to fill a trade are at the asking price when buying, and the bid price when selling. So, if you use a market order, do not expect a fill near the mid-price

Limit Sell Order Example

To understand how a limit sell order works, consider an investor who owns stock currently trading for $40 per share. If the investor wanted to sell their shares at a price of $45 or higher, they could route a limit sell order with a price of $45:

sell Limit Order

As illustrated in the above visual, a limit sell order with a price of $45 will only be completed if the shares can be sold for $45 or higher. Using a limit sell order is favorable because the worst case scenario for a fill is the price you specified, but you can also get filled at a more favorable (higher) price.

Limit Buy Order Example

To understand how a limit buy order works, consider an investor who wants to buy a stock when it reaches a price of $42.50 or lower, but the stock is currently trading for $50. With a target purchase price of $42.50, the investor could route a limit buy order with a price of $42.50:

limit buy order

With a limit buy price of $42.50, the trade will only be completed if the fill price is $42.50 or lower. Limit buy orders are favorable because the worst price you can get filled at is the price you specify, and there’s always a chance you get filled at an even better (lower) price.

Good-Til-Canceled (GTC) Orders

If not filled or canceled, a limit order automatically expires at the end of the trading day in which the order was initiated (but may vary depending on your brokerage). However, if an investor wishes to keep a limit buy or limit sell order active for longer periods of time, a good-til-canceled (GTC) order can be used. 

While “good-til-canceled” infers that the order will remain until canceled, brokerage firms may set a limit for the number of days a GTC order can be active. So, GTC orders will still expire at some point, but are still helpful to use for orders you wish to let sit for weeks at a time.

Stop-Loss Orders

When an investor wants to automatically exit a losing trade when the stock or option reaches a certain price, stop-loss orders can be used. Stop-loss orders are typically market orders, but can also be limit orders (stop-limit). In this guide, we’ll focus on regular stop-losses that use market orders.

While “good-til-canceled” infers that the order will remain until canceled, brokerage firms may set a limit for the number of days a GTC order can be active. So, GTC orders will still expire at some point, but are still helpful to use for orders you wish to let sit for weeks at a time.

Stop-Loss Sell Order Example

To understand how a stop-loss sell order works, consider an investor who purchased stock for $50 per share. If the investor wanted to automatically exit the position if the stock price falls to $40, a stop-loss sell order with a price of $40 could be implemented:

While “good-til-canceled” infers that the order will remain until canceled, brokerage firms may set a limit for the number of days a GTC order can be active. So, GTC orders will still expire at some point, but are still helpful to use for orders you wish to let sit for weeks at a time.

stop loss sell

As soon as the shares trade $40, a market order to sell the shares will be executed.

Stop-Loss Buy Order Example

A stop-loss buy order can be used to close a short stock or option position when a certain price is reached. For example, consider a trader who shorts a stock at $70 per share. If the trader wanted to cut their losses when the stock rises to $75, a stop-loss buy order can be implemented:

If the shares trade $75, a market order to buy back the short shares will automatically be executed.

There is even an order type that combines a stop order and a limit order. This is called a stop-limit order. Read more about stop-limits here!

TIF Order Types

TIF (time-in-force) orders can be designated in numerous different ways. These communicate to a broker when and for how long a trade should remain working. Some of these include DAY, GTC, GTD, EXT, GTC-EXT, MOC, LOC. Read more about these order types in our article on TIF order types here!

Additional Notes on Using Stop-Loss Orders

The stop-loss examples above assumed that an investor already had a long or short position in the asset before implementing a stop-loss order. However, it’s important to note that stop-loss orders can be implemented without having a long or short position. 

For example, if a trader routes a $100 stop-loss buy order on a stock they aren’t short, the trader will automatically buy the shares if the stock rises to $100. Conversely, if a trader routes a $50 stop-loss sell order on a stock they don’t own, the trader will automatically short the shares if the stock falls to $50.

Unless you’re a trader using stop-loss orders for momentum-based entries, entering long stock positions at higher prices than the current share price or entering short stock positions at lower prices than the current share price doesn’t make sense. Because of this, stop-loss orders should be canceled if the underlying positions are closed before the stop-loss orders are executed.

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Additional Resources

Mastering the 4 Different Types of Option Orders – Option Alpha

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