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Month: March 2022

Options Trading Approval Levels: Broker Guide

Posted on by Mike Martin

Last updated on March 24th, 2022 , 07:16 am

Options Trading Levels

           TAKEAWAYS

  • In order to trade options, investors must first apply for and be granted options trading approval.

  • Option trading levels vary by the broker; some have only 3 levels of options trading approval (tastyworks) while other brokers have 5 levels (Fidelity).

  • Selling naked options always falls under the last tier, as this strategy has the greatest risk.

  • Brokers look at both a customer’s financial condition and investing history before making a decision to accept or reject an options approval request.

  • If an investor’s request for options trading approval is rejected, that investor can reapply at a later date. 

Options trading can be a precarious endeavor. It is not a “one-size-fits-all” business. 

Certain options strategies, such as the “short call”, introduce traders to infinite risk.

Because of this risk, specific strategies are not suited for everyone. 

In order to protect both customers and brokers from this risk, “Options Trading Approval Levels” were introduced. Investors must apply and be approved for options trading before they can trade even the most basic options strategies. 

Unfortunately, there are no standardized levels of options approval. The broker gets to choose what strategies fall under what tiers. 

To make things more complicated, many brokers have different “tiers” of options approval. Most have 3, but others have 5. You can call your broker and request their specific option approval documentation at any time.

 

How Do You Get Options Approval?

In order to trade options in your account, you must apply for options trading approval with your broker. Part of this process involves receiving a copy of a publication from the Options Clearing Corporation entitled the “Characteristics and Risks of Standardized Options.”

This document is very important for new traders to read. Among other helpful bits of information, it contains:

It generally takes 1-3 business days for your broker to review and either accept or decline your request. 

What is Required to Get Options Trading Approval?

Just because you apply for options trading approval does not necessarily mean you will get it. According to the SEC, you must meet certain criteria to trade options. 

Your broker will ask you many personal questions about your trading history and financial condition. Some of these include your:

  • Investment Objectives (capital preservation, income, growth, or speculation)
  • Trading Experience (how long you have traded stocks/options, what size you trade and general investing knowledge)
  • Personal Financial Situation (liquid net worth, total net worth, annual income, and employment status)

A lot of this is very personal indeed! So how does your broker know if you’re making your answers up? They generally won’t. With that being said, to avoid financial ruin, it is best to stick with trading what you know and understand. That is the aim of this process. 

You can always apply later on to “upgrade” your approval after you gather the necessary trading knowledge, or bankroll!

General Option Trading Levels

Before we start comparing the different approval levels offered by popular brokers, let’s review the most common “3 tier” option trading level structure, as well as the different strategies permitted in these levels. 

Please keep in mind these levels are focusing on basic margin accounts; we will get into options trading approval for cash and IRA accounts later on.

Level One Options Approval

● Covered calls

● Buying call options and buying put options (sometimes)

Level Two Options Approval

● All level one strategies

● Defined-risk spreads

● Cash-secured naked puts

Level Three Options Approval

● All level one and level two options strategies.

● Undefined-risk spreads

● Naked call and put options

Option Trading Approval Levels by Broker

Brokers are required to create their own option approval levels. Because of this, there are no standardized options trading approval tiers. 

Most brokers currently offer 3 levels of options approval, with “Level 1” being the most basic (covered calls) and “Level 3” the most advanced (selling options naked). However, most traders will find everything they need under “Level 2”.

We can’t list every broker on this list, but we will try and cover the various options trading levels offered by the most popular brokers. 

Tastyworks Option Approval Levels

tastyworks offers three different levels of options trading. Unlike other brokers, they use more fun verbiage, such as “Limited” (level one) “Basic” (level two) and “The Works” (level three). As we can see below, they offer different features depending on the account type (margin vs IRA).

tastyworks

tastyworks options approval levels

Source: tastyworks trading levels

Fidelity Option Approval Levels

Fidelity has 5 different option approval levels. This makes the process a little more complicated and is just another reason why tastyworks is our preferred broker. 

The below screenshot, taken from Fidelity Investments, shows what is included in their various tiers of options approval. 

Fidelity

Fidelity Option Approval Levels

E*TRADE Option Approval Levels

E*TRADE has 4 different levels of options trading approval. Like almost all levels on our list, naked options come under the last tier. 

Because of the great risk that comes with selling options, this tier is usually the hardest to get approved for. 

E*TRADE

etrade option approval levels

Robinhood Option Approval Levels

Robinhood has only two tiers of options approval. Additionally, Robinhood does not allow their customer to sell options naked or trade undefined risk spreads! 

The below image shows what options strategies are available at Robinhood and their corresponding tiers:

Robinhood

TD Ameritrade (thinkorswim) Option Approval Levels

thinkorswim/TD Ameritrade (soon to become Charles Schwab) offers four levels of options approval. Like other brokers on our list, the type of options approval you can qualify for at TD will depend on your type of account. 

When compared to IRA and cash accounts, margin accounts always offer more flexibility in terms of strategies. 

Ameritrade

Option Approval FAQs

Many brokers allow for options trading in an IRA account. The strategies offered in IRA accounts are often limited. Since only so much can be contributed to an IRA every year, options strategies with undefined risk are not permitted in an IRA account. This includes selling naked call options. How would an investor compensate their broker if a trade were to move against them beyond the limits of their account value?

Some brokers allow options trading in cash accounts while other do not. When compared to margin accounts, cash accounts approved for options trading have far fewer options in terms of strategies. 

In order to get approved for a higher option trading approval level, you must apply with your broker. Many times, these request are denied due financial conditions or a lack of investment knowledge. However, investors can reapply at a later date. 

Next Lesson

VXX Alternatives: UVXY vs VIXY vs VIXM vs VXZ vs SVXY vs UVIX vs SVUX

Posted on by Mike Martin

Last updated on April 1st, 2022 , 05:48 am

Volatility ETFs Infographic

In March 2022, Barclays suspended sales of its wildly popular iPath Series B S&P 500 VIX Short-Term Futures ETN, better known as VXX. 

Though it will be hard in the short term for competitive ETFs (and ETNs) to match VXXs liquidity, there are indeed alternatives to Barclay’s VXX ETF.

All market volatility products in this article come with significant risks. To learn more about these risks, read this alert from the SEC.

Let’s fly over a few of the different futures-based volatility ETFs investors have before analyzing and comparing them individually. 

  1. UVXY: ProShares Ultra VIX Short-Term Futures ETF

  2. VIXY: ProShares VIX Short-Term Futures ETF

  3. VIXM: ProShares VIX Mid-Term Futures ETF

  4. VXZ: iPath Series B S&P 500® VIX Mid-Term Futures ETN

  5. SVXY: ProShares Short VIX Short-Term Futures ETF

UVXY vs VIXY vs VIXM vs VXZ vs SVXY

UVXY VIXY VIXM VXZ SVXY

Fund Name:

ProShares Ultra VIX Short-Term Futures ETF

ProShares VIX Short-Term Futures ETF

ProShares VIX Mid-Term Futures ETF

iPath Series B S&P 500 VIX Mid-Term Futures ETN

ProShares Short VIX Short-Term Futures ETF

Market Direction:

Long

Long

Long

Long

Short

Leverage Ratio:

1.5X Leverage

1x Leverage

1x Leverage

1x Leverage

.5x Leverage

VIX Duration Structure:

Short-Term Futures

Short-Term Futures

Mid-Term Futures

Mid-Term Futures

Short-Term Futures

Average Volume:

82,945,752

9,124,628

146,211

56,690

5,823,345

AUM (Assets Under Management):

$840.39M

$363.87M

$108.19M

$65.58M

$425.01M

Expense Ratio:

0.95%

0.85%

0.85%

0.89%

0.95%

How does the UVXY ETF work?

  • ProShares UVXY ETF (exchange-traded fund) rises in value with increases in the expected volatility of the S&P 500 as measured by VIX futures; UVXY does NOT track the VIX (aka “fear index”) directly.


  • UVXY tracks the return of numerous VIX futures with a weighted average time until expiration of one month.


  • UVXY seeks a leveraged return 1.5x the return of the short-term VIX futures index it tracks on a daily basis.

  • Due to the compounding of returns, positon’s held in UVXY for more than a single day can deviate greatly from the benchmark.


  • “Roll Yield” contributes to UVXY’s profound decay.

Out of all the funds on our list, UVXY is the most liquid. With an average of 83 million shares traded every day, traders should have little slippage entering and exiting positions. Also worth noting is the funds very high expense ratio of 0.95%!

Like most funds on our list, ProShares UVXY ETF tracks the S&P 500 Short-Term VIX Futures Index. Let’s first see how ProShares describes their fund in the ETFs prospectus:

 

Since VIX Futures expire regularly, short-term futures ETFs must contain more than one contract to provide their average one to expiration ideal holdings. Let’s see what’s under the hood next.

UVXY Holdings and Performance

The below image, taken from ProShares’ prospectus of UVXY, shows the funds current holding:

UVXY holdings

We can see that UVXY currently has a larger position in VIX April futures than VIX May futures (far right side of the above image). As time advances, and the April expiration approaches, the position will be increasingly rolled out to May. 

UVXY is the only leveraged ETF on our list. What the fund does not list in its holdings are the securities they utilize to achieve this leverage. 

However, we can read in the prospectus that ProShares implements derivatives, such as “swaps”, to achieve this leverage. 

Due to the nature of both swaps and contango, UVXY perpetually sheds value, as can be seen in the below one-year performance chart. 

Want to learn how Contango works? Check out our article on Contango written by Chris Butler!

UVXY One Year Chart

UVXY one year chart

If you’d like an in-depth review of UVXY, please check out our article, “UVXY: What Is It and Is It Worth The Risk?“

How does the VIXY ETF work?

  • ProShares VIX Short-Term Futures ETF (VIXY) rises in value with increases in the expected volatility of the S&P 500 measured by VIX futures contracts.

  • VIXY is NOT a leveraged ETF but aims for a 1x return of its benchmark, the VIX Short-Term Futures Index VIX.

  • Like UVXY, VIXY uses futures with a weighted average of one month to expiration.

  • Like UVXY, VIXY is intended for short-term use; over a period of more than one day, the ETF often fails to track the index adequately because of contango.

VIXY has a lot in common with UVXY, with three notable exceptions:

UVXY vs VIXY: 3 Differences

  1. Unlike UVXY, VIXY is not a leveraged product, and decays less over time because of this. 

  2. VIXY is less liquid than UVXY.

  3. VIXY charges a fee of 0.85%, which is less than UVXY’s fee of 0.95%.

If you understand UVXY, you should have a pretty good idea of how VIXY works. The only difference is this fund is not leveraged. Let’s take a quick look at how ProShares describes their fund, then move on to the holdings and performance of UVXY.

 

VIXY Holdings and Performance

The below image, taken from ProShares’ prospectus of VIXY, shows the funds current holding:

VIXY Holdings

ProShares VIX short-term futures ETF (VIXY) is very similar in nature to UVXY.

We can see they are currently invested in both April and May VIX futures. The proportion of these two months is also nearly the same. VIXY, however, has a lesser quantity of VIX futures than UVXY. Why? Because VIXY is not as popular as UVXY. 

Let’s compare the two next. Remember, UVXY is a leveraged ETF (1.5x), VIXY is not!

 

UVXY vs VIXY: One Year Chart

UVXY vs VIXY Performance

The above chart shows just how much faster the leveraged UVXY ETF decays when compared to VIXY. This is due of course to the leverage of 1.5 that UVXY utilizes.

In addition to contango, leveraged ETFs also decay because of their derivative nature. Double whammy!

Short-Term vs. Mid-Term Volatility ETFs

The next two funds we will be reviewing both track the performance of the S&P 500  VIX Mid-Term Futures Index. Though the short-term and mid-term VIX Indices are indeed similar (CBOE ticker SPVIXSTR and SPVIXMTR respectively),  there are some important differences in the structure and performance of volatility products the track them:

  • Short-term ETFs decay more rapidly than mid-term ETFs.

  • Short-Term VIX ETFs incorporate two VIX futures expirations.

  • Mid-Term VIX ETFs incorporate four VIX futures expirations.

Let’s jump into ProShares mid-term volatility ETF (VIXM) first.

How does the VIXM ETF work?

  • ProShares VIX Short-Term Futures ETF (VIXM) rises with increases in the expected volatility of the S&P 500, as measured by the prices of VIX futures contracts.

  • VIXM is NOT a leveraged ETF.

  • VIXM aims to provide long exposure to the S&P 500 VIX Mid-Term Futures Index.

  • The Mid-Term Futures Index is a portfolio of monthly VIX futures contracts with an average of five months to expiration.

As stated by ProShares, the VIXM ETF aims to:

In order to fully understand how VIXM differs from VIXY, we must dive into the funds holdings:

VIXM Holdings and Performance

The below image, taken from ProShares’ prospectus of VIXM, shows the funds current holdings:

VIXM Holdings

As we can see, this ETF has positions in July, August, September, and October futures contracts.

The result is a weighted average of five months to expiration.

So what effect does this more time-diverse product have on the performance of VIXM? Let’s look at a 5-year chart comparing VIXM with its short-term futures ETF counterpart, VIXY:

 

As the above image clearly shows, the short-term futures ETF VIXY erodes at a far greater pace than the mid-term futures ETF VIXM.

Why is this? Contango! When futures are rolled, sometimes a premium must be paid above the spot price to do this. This premium is far greater in short-term futures than mid-term futures.

The below image (from spreadcharts.com) shows the cost of contango for short-term futures (gold) and longer-term futures (blue).

contango mid term vs short term futures

How does the VXZ ETF work?

  • iPath’s Series B S&P 500® VIX Mid-Term Futures ETN (VXZ) is designed to provide exposure to the S&P 500 VIX Mid-Term Futures underlying Index

  • VXZ is classified as an ETN (exchange-traded note)

  • VXZ performs similar to VIXM

As stated by the funds prospectus, VXZ aims to:

iPath’s Series B S&P VIX Mid-Term Futures ETF VXZ (issued by Barclays Capital) has a lot in common with VIXM.

One ostensible difference is in the funds’ nomenclature: VXZ is called an ETN. ProShares calls their funds ETFs. The truth is all futures-based ETPs (exchange-traded products) are ETNs. Good for iPath for calling a spade a spade! So what’s the difference between an ETN and an ETF?

Basically, an ETN is a debt security issued by a bank. ETNs don’t pay dividends and therefore have tax advantages (there are no dividends to tax).

If you’d like to compare the differences between ETNs and ETFs in-depth, check out our article, “ETN vs ETP vs ETC vs ETF“.

But, again, all the “funds” listed in this article are ETNs. ETFs generally perform more like mutual funds in that most have equity exposure. 

VXZ is an inferior product to VIXM in almost every way. Here are a few

VIXM vs. VXZ: 3 Differences

  • VXZ charges a fee of 0.89%; VIXM charges a fee of 0.85%.

  • VIXM trades an average of 150k shares/day; VXZ trades an average of 56k shares/day.

  • VXM option markets are incredibly wide.

Options traders should avoid VXZ at all costs. Limit orders are essential here. 

Why? In addition to VXZs low open interest and volume, you could park a truck between the bid/ask spread!

Take a look at the current options markets for VXZ calls and puts on tastyworks:

VXZ Options

VIXM vs VXZ: Performance

Let’s end our mid-term futures-based ETFs segment by taking a look at the historical 3-year performance of ProShares’ VIXM (blue) and iPaths’ VXZ (grey) ETNs. As you can see, they perform almost the exact same.

VIXM vs VXZ 3 Year Performance

Chart from barchart.com

How does the SVXY ETF work?

  • ProShares Short VIX Short-Term Futures ETF (SVXY) is benchmarked to the S&P 500 VIX Short-Term Futures Index.

  • SVXY is a SHORT ETF, meaning this product rises in value when volatility decreases.

  • SVXY attempts to replicate -0.5x the return of the S&P VIX Short-Term Futures Index.

Last on our list is an inverse fund: ProShares SVXY. SVXY is currently the only inverse volatility ETF in existence. Here is how ProShares describes their fund in the prospectus:

SVXY Holdings and Performance

The below image, taken from the prospectus of ProShares Short VIX Short-Term Futures ETF (SVXY), shows the funds current holdings.

SVXY holdings

The holdings of SVXY are very similar to those of UVXY and VIXY. The one notable exception is that the futures contracts held with SVXY are short, not long. 

Not shown in the holdings are SVXYs leverage structure: this fund shorts the S&P 500 VIX Short-Term Futures Index at half leverage.

As we said before, because of contango, short-term (and mid-term) futures-based ETFs are a bad idea. So if buying them is a poor investment, wouldn’t selling them be a good idea? Sometimes. And this is the reason behind SVXYs high trading volume. 

Let’s compare a 5-year chart of SVXY to VIXY. Remember, SVXY is leveraged at a 0.5x ratio while VIXY is leveraged at a 1x ratio. 

One Year Chart: SVXY vs VIXY

svxy vs vixy one year

Based only on this chart, SVXY may seem like a decent long-term investment. 

Let’s compare the same ETFs, but let’s now extend the chart to 5 years. 

Five Year Chart: SVXY vs VIXY

Pay particular attention to what happened in 2018. This event was known as “Volpocalypse“. 

This event occurred in February of 2018 when the VIX doubled and the markets tanked. 

I was working with several advisors during this time that were short put options in SVXY. Needless to say, it was a bad day for them!

UVIX vs SVIX

On the tail of Barclay’s shutting down VXX, Volatility Shares announced the launch of to two new products:

  1. UVIX: 2X Long VIX Futures ETF
  2. SVIX:-1X Short VIX Futures ETF

The 2x Long VIX Futures ETF (Ticker: UVIX) seeks to provide daily investment results, before fees and expenses, that correspond to 2x the Long VIX Futures Index (Ticker: LONGVOL).

➥Want to learn more about this ETF? Check out our article, What is UVIX?

The -1x Short VIX Futures ETF (Ticker: SVIX) seeks to provide daily investment results, before fees and expenses, that correspond to the Short VIX Futures Index (Ticker: SHORTVOL).

➥ Want to learn more about this ETF? Check out our article, What is SVIX?

 

Risks of VIX ETFs

Let’s conclude the article by going over two major risks that volatility-based products introduce to traders:

1.) Volatility ETFs Do No Track the VIX

Because of contango and backwardation, volatility ETFs diverge substantially from the VIX spot index. 

2.) Volatility ETFs Shed Value Persistently

In normal markets, volatility ETFs perpetually decline in value. The exception here of course is SVXY, but after learning about “volpocalypse” we can see that not even these products are safe!

Back to Volatility Guides ➥

Recommended Video

Next Lesson

ETF vs. ETN vs. ETP vs. ETC: Here’s How They Differ

Posted on by Mike Martin

Last updated on April 7th, 2022 , 06:43 am

3 Different Types of Exchange Traded Products

Exchange-traded products (ETPs) allow investors access to securities without having to directly invest in those securities. These securities include, but are not limited to 1.) baskets of stocks 2.) debt instruments 3.) individual or baskets of commodities. 

This article is going to explore and compare a few of the more popular exchange-traded products. All products on our list are exchange-traded, meaning you can trade them with your broker on stock exchanges. 

Let’s start off with a brief description of the various ETPs we will be exploring and comparing in this article:

1.) ETP (Exchange-Traded Product)

All of the securities on our list fall under the ETP (exchange-traded product) umbrella. 

2.) ETF (Exchange-Traded Fund)

ETFs are the most popular and generally the most liquid of products of all ETPs. An ETF is a basket of securities that tracks an underlying index, typically composed of stocks. 

3.) ETN (Exchange-Traded Note)

ETNs are bank-issued unsecured debt securities. ETNs track an underlying index without owning the underlying asset.

4.) ETC (Exchange-Traded Commodity)

ETCs are exchange-traded products that track and fluctuate with the price of a commodity or a basket of commodities. ETCs are most common in Europe. 

ETP vs ETF vs ETN vs ETC Explained

What is an ETP (Exchange-Traded Product)?

  • ETPs track securities on a wide array of securities, such as stocks, bonds, cryptocurrencies, normal currencies and commodities.
  • ETPs trade on exchanges just as stocks do.
  • ETPs generally provide investors with a more cost-efficient alternative to mutual funds. 
  • The value of ETPs is in constant flux with the market. 

Exchange-Traded Products (ETPs) Definition: ETPs are financial products that trade on public exchanges that give investors exposure to a wide array of securities.

All funds on our list (ETFs, ETNs, and ETCs) are considered exchange-traded products.

These funds have been exploding in popularity. Why? ETPs offer investors a simple and low-cost way to diversify their portfolios.  Some ETPs funds offer investors access to thousands of underlying stocks!

Unlike mutual funds, ETPs trade actively during market hours. You can buy and sell ETPs at any time of the day. These funds can even be traded when the market is closed when using the EXT TIF order type. 

This is unlike mutual funds, which can only be open and closed at one point of the day. Additionally, the fill price you receive on mutual funds is unknown. With ETPs, you can use specific order types, such as a limit order, stop-limit order, and stop-loss order.

The most popular ETP is the ETF. Let’s take a look at exchange-traded funds next!

What is an ETF (Exchange-Traded Fund)?

  • ETFs trade on an exchange and can be purchased and sold just like stocks can. 
  • ETFs cover a wide spectrum of investments, which include domestic stocks, international stocks, commodities, and bonds.
  • ETFs are growing in popularity among long-term investors due to their low cost, high liquidity nature.

Exchange-Traded Fund (ETF) Definition: ETFs represent a basket of securities investors can buy or sell through a brokerage firm.

The vast majority of ETPs are ETFs. According to Business Insider, 97% of the $5 trillion global ETP market consists of exchange-traded funds. 

So how do ETFs work? For an in-depth analysis, check out our article “ETFs Explained: Investing Basics”.

In a nutshell, here’s how ETFs work:

How Are ETFs Created?

  1. An ETF issuer creates a fund that holds the underlying securities.
  2. The fund is broken down into individual shares which smaller individual investors can buy and sell.
  3. These shares are listed on an exchange and actively traded.

After an ETF is listed, authorized participants are called upon to keep the value of the ETF in line with that of the underlying basket of securities. If the fund is trading above its NAV (net asset value), these participants will purchase shares of the individual securities that constitute the fund to bring their value in line with the ETF.

So how many types of ETFs are there? A lot! Here are a few of the more popular fund types.

Types of ETF Asset Classes

  • Stock (Equity) ETFs

Stock market ETFs are created to track equity sectors and indices. The most popular of all ETPs is State Street’s SPY ETF. SPY is an index fund that tracks the performance and yield of all 500 stocks within the S&P 500 benchmark index. They do this for the low expense ratio (fee) of 0.09%

  • Bond ETFs

Bond ETFs provide investors with a regular source of income. Bond ETFs are less concerned with price appreciation for this reason. When purchasing bond ETFs, always look at the yield before looking at the ETFs’ historical performance!

  • Commodity ETFs

Commodity ETFs invest in physical commodities. These can include oil, gold, currencies and precious metals. 

Unlike other ETFs, commodity ETFs generally only invest in a single commodity. Because of this lack of diversification, you may be wondering why these products are called “funds” at all. Some countries don’t consider these products’ ETFs for this reason, but ETCs (exchange-traded commodities). More on this to come!

Commodity ETFs can either 1.) hold the actual physical commodity or 2.) hold futures contracts that track the performance of that commodity. 

When tracking commodities via futures contracts, commodity ETFs can deviate greatly from the “spot” price of the actual commodity. This is called “contango” and “backwardation”. You’ve been warned!

  • Cryptocurrency ETFs

Cryptocurrency ETFs are the newest ETPs on our list. The most popular crypto ETF is BITO by ProShares. This is a bitcoin-linked ETF that tracks the coin via futures contracts. Refer to our above caution box to see why this may be a bad idea!

If you’d like to learn more about Proshares BITO ETF check out our article, “ProShares BITO ETF Explained“.

  • Leveraged ETFs

Leveraged ETFs provide investors with leveraged exposure to an underlying commodity or basket of securities. Leveraged ETFs use opaque “swap” contracts to achieve this leverage. The greater the leverage, the greater the tracking error and risk. The below image (from Tony Cooper) shows the historical return of various leveraged products over a long duration. Leveraged ETFs are not designed for long-term investors.

Leveraged ETF Study

Some of the more popular leveraged ETFs include:

  • SPUU (Direxion Daily S&P 500 Bull 2X Shares ETF)
  • UPRO (The Direxion Daily S&P 500 Bull 3x ETF)
  • QLD (ProShares Ultra QQQ 2x ETF)
  • TQQQ (Proshares Ultra QQQ 3x ETF)

Learn more about leveraged ETFS in our video below!

Additionally, ETFs can be options-based. Options trading (specifically covered call writing) can provide investors with extra income – and risk!

Read: 7 Covered Call ETFs and How They Work

What is an ETN (Exchange-Traded Note)?

  • ETNs are unsecured, bank-issued debt securities that trade on exchanges just as stocks do.
  • ETNs are similar to bonds in structure with the exception ETNs do not pay dividends, so there are no distributions to tax.
  • At the maturity date, ETNs pay the value of the index minus any fees. 

Exchange-Traded Note (ETN) Definition: ETNs are unsecured debt securities that track an underlying index. Issuer risk is present in ETNs.

Exchange-traded notes are a bit more nebulae than ETFs. Perhaps the greatest distinction lay in their constitution. ETNs, unlike ETFs, do not actually own the securities of the index it tracks. 

Instead, through various financial instruments, ETNs simply pay the return of a specific index. With no actual security base, ETNs behave more like bonds.  

Since there are no underlying securities held, the health of ETNs is contingent upon the health of the issuing financial institution. Therefore, the credit rating of the issuer is of utmost importance in determining an ETNs credit risk.

Some of the more popular ETNs include market volatility products related to the VIX index include Barclays iPath Series B S&P 500 VIX Short-Term Futures ETN (VXX) and ProShares Ultra VIX Short Term Futures ETF (UVXY). During the financial crisis, many volatility products imploded. 

What is an ETC (Exchange-Traded Commodity)?

  • ETCs (exchange-traded commodities) are the European equivalent of American single commodity-based ETFs.
  • ETCs are most similar to ETFs and are settled in the same fashion.

Exchange-Traded Commodity (ETC) Definition: ETCs (most common in Europe and Australia) are bank-issued securities that track a single commodity. 

We covered earlier the various exchange-traded funds (ETFs) that track commodities.

In Europe and Australia, these types of funds are called exchange-traded commodities (ETCs). 

Why? The regulatory bodies of these countries do not believe these types of products should be called “funds” due to their lack of diversification. 

Like American commodity ETFs, ETCs can be linked to a commodity through its spot price or via the futures market. As we said before, products that are linked via futures have more risk than those linked via the spot market.

Let’s take a closer look at the differences between ETFs and ETCs next, then finish the article by comparing all 3 types of funds on our list.

Exchange-Traded Fund (ETF) vs Exchange-Traded Commodity (ETC)

ETF vs ETC: Regulation and Nomenclature

  • ETCs fall under the EU’s directive UCITS (Undertaking for Collective Investment in Transferable Securities), which requires funds with exposure to only one commodity be deemed an “ETC”, or exchange-traded commodity. ETCs that contain a basket of commodities can indeed be called an ETF under this ruling. 
  • In the United States, commodity ETFs are regulated by the Commodities Futures Trading Commission (CFTC). The CFTC allows commodity funds to be called “ETFs” even when that fund invests in a  single commodity. 

ETF vs ETC: Risk Exposure

  • Commodity ETFs invest directly in a commodity, either via the spot market or futures contracts, and have market risk.
  • Exchange-Traded Commodities (ETCs) are debt securities issued by banks and therefore have default and market risk.

ETF vs ETN vs ETC: What's The Difference?

ETF (Exchange-Traded Fund) ETN (Exchange-Traded Note) ETC (Exchange-Traded Commodity)

Asset Category

Broad

Unsecured Debt

Commodity 

Risk

Market Risk

Market Risk; Issuer Risk

Market Risk; Issuer Risk

Liquidity

Most Liquid

Less Liquid

Less Liquid

Tracking Error

High

Low

Low

Dividends

Usually Yes

No

No

Tax Treatment

Short or Long-Term Capital Gains Tax.

Short or Long-Term Capital Gains Tax.

Varies

ETF vs ETN vs ETC: FAQs

Though both ETFs and ETNs have similarities, they are structurally different. ETFs provide investors direct exposure to securities while ETNs are unsecured debt securities that track an underlying index without owning the underlying.

In addition to market risk, exchange-traded notes are subject to issuer risk. ETNs are as safe as the bank that issues them. When trading ETNs, make sure the issuing financial institution has a high credit rating. 

ETNs offer investors the benefit of access to hard-to-reach markets and accurate tracking performance. ETNs also do not issue dividends, so no tax is paid on dividends.

Exchange-traded commodities (ETCs) are not considered funds in the eyes of the European Union because they are not diversified. 

Supplemental Reading

Exchange-Traded Notes: An Alternative To ETFs – Investopedia

Next Lesson

VIX Contango: The Ultimate Beginner’s Guide

Posted on by Chris Butler

Last updated on March 28th, 2022 , 02:05 pm

VIX Contango: The Ultimate Beginner's Guide

Stock market volatility products are confusing for beginner market participants because of their complexity.

Fear not!

In this particular guide, you will develop an understanding of:

  • Contango and backwardation in the Cboe volatility index (VIX) market

  • The major implications it has for the performance of popular volatility products such as VXX and UVXY.

  • VIX trading strategies for contango and backwardation market conditions

Prepare to take one step closer to becoming a master of the VIX/volatility landscape!

What is Contango?

“Contango” refers to a situation where futures contracts trade at a premium to the “spot” price (the current price) of a commodity/index.

For example, if the Cboe VIX index is at 15 and the VIX futures contract settling in 30 days is 17, we have contango in the VIX futures market.

Here’s a simple example visualization of contango:

When VIX futures are trading above the VIX index, contango is present. The result is an upward-sloping curve.

Contango is typically present in the VIX market, making it more useful to understand than backwardation (the opposite of contango). We will briefly cover backwardation in a later section.

Why is Contango Important to Understand?

Contango in the VIX market drives the performance of volatility products and trading strategies, so understanding it will help you make more informed trades.

In the VIX market, the VIX index is the calculation of expected S&P 500 volatility based on 30-day S&P 500 index (SPX) option prices. But we can’t directly trade the VIX index because there are no VIX shares. To trade VIX index predictions, traders turn to VIX options and futures.

But before trading futures, it’s essential to understand how futures prices perform over time relative to the spot price.

Futures Prices Converge to the Spot Price

A critical concept to understand in futures markets is that futures prices converge towards the spot price over time:

Futures prices converge to the spot price over time. On the settlement date of a futures contract, its price will equal the spot price of the commodity it tracks.

On a futures contract’s expiration date, the contract’s price will equal the spot price.

A futures contract with no future equals the spot price.

For example, if the VIX index is at 15 and a 30-day VIX futures contract is at 17, the contract’s price will fall from 17 towards 15 with each passing day if the VIX index remains at 15:

The above image illustrates how a futures price converges to the spot price over time if the spot price remains constant.

In reality, the VIX index will fluctuate as market volatility changes, but volatility index futures will get “pulled” towards the index as their settlement dates approach.

Here’s a visual using real historical data to prove this:

VIX futures prices converging to the VIX index as their settlement dates approach.

As we can see, each contract’s price equals the VIX index value at expiry.

What can we do with this information?

The VIX Futures Curve

Volatility traders pay close attention to the “VIX futures curve” or “VIX term structure” because it can inform them of how volatility products will perform over time if volatility remains unchanged. It also tells us how much we need the VIX index to change for our volatility trades to work out.

The “VIX futures curve” is simply a chart of the prices of VIX futures contracts with varying expiration dates, from shorter-term to longer-term.

VIX Central is a free resource for visualizing the current VIX futures curve, as well as viewing historical curves.

VIX Contango Example

When the VIX futures are in contango, we get an upward-sloping curve, indicating that longer-term contracts are more expensive than shorter-term contracts:

VIX Central futures curve from January 2017 displaying contango.

VIX Backwardation Example

When the VIX futures are in backwardation, we get a downward-sloping curve, indicating that longer-term contracts are cheaper than near-term contracts.

The current futures curve is in backwardation as I write this in March 2022:

VIX futures in backwardation. Longer-term contracts are more expensive than short-term contracts.

In the above curve, the March and April contracts are trading at the level of the VIX, but the longer-dated contracts are at lower and lower values the further out the settlement date.

During normal/low volatility market periods, the VIX futures are usually in contango. We’ll explore the intuitive understanding of why that is in a later section.

VIX Futures Contango vs. ETP Performance

The performance of VIX futures determines the performance of popular volatility exchange-traded products (ETPs).

For example, the daily performance of VXX is equal to the daily percentage changes of front-month and back-month VIX futures. Be sure to read our guide on VXX for an in-depth understanding of this product’s mechanics.

When VIX futures contango is present, short-term VIX futures contracts will bleed value with each passing day if the VIX index does not increase.

The result? Long volatility products like VXX and UVXY will experience drawdowns since their performance stems directly from daily changes in VIX futures. Short volatility products like SVXY and SVIX benefit from persistent contango.

Why Are VIX Futures Usually in Contango?

During normal market conditions, the Cboe VIX Index is typically below 20. When the VIX is below 20, it’s common for contango to be present in the VIX futures market.

An easy way to understand why is to think of a VIX futures contract as insurance. When stock market volatility increases, the VIX index and futures rise, making them popular hedging instruments for risk managers.

During a financial crisis, such as in 2008 or 2020, the VIX index and futures spiked as the stock market collapsed violently.

Here’s how the volatility index futures reacted to the VIX spike in 2008:

In 2008, the VIX index spiked over 80 as the market collapsed. VIX futures also increased as they were pulled higher by the VIX.

If the market is in a low volatility period, risk management desks might buy VIX futures to hedge their portfolios against an increase in market volatility. As seen above, long positions in volatility index futures will gain value during market crises. The profits from these long volatility positions will offset losses in long equity positions.

Since futures contracts have expiry dates, volatility traders must decide between hedging short-term and long-term.

Generally speaking, there’s a higher probability of negative events occurring over a longer period of time (such as five years) as opposed to a shorter period of time (such as one month).

The probability of the market falling 10% is higher over a 1-year period than a 1-week period.

As a result, buying long-term VIX futures provides traders with a long duration of protection, justifying a higher price compared to buying a short-term future that provides only a small window of protection.

And so during normal market conditions, longer-term volatility futures trade at higher prices than shorter-term volatility futures, resulting in contango in the VIX futures market.

How can traders take advantage of contango in the VIX?

VIX Contango Trading Strategies

When contango is present, VIX futures and long volatility products like VXX and UVXY all predictably lose value if the VIX does not increase.

The VIX index is directly tied to the realized S&P 500 volatility.

If S&P 500 volatility increases, traders will bid up SPX option prices (which are used to calculated the VIX) as the expected movements of the S&P 500 index increase.

If S&P 500 volatility falls, the expected movements of the S&P 500 index contract. SPX option prices will fall (VIX falls).

The VIX Index follows the actual volatility of the S&P 500.
What does this have to do with contango?
 
If VIX contango is present and traders believe S&P 500 volatility will remain unchanged or decrease, profits can be made from short volatility trading strategies, including:

  • Shorting VIX futures

  • Shorting VXX/UVXY shares

  • Buying puts on VIX/VXX/UVXY

  • Shorting calls on VIX/VXX/UVXY

These strategies can profit from persistently low market volatility, as the VIX futures will remain in contango and steadily lose value as they converge towards the lower VIX spot price (visualized earlier in this post).

However, traders should be cautious with short volatility trading strategies because when market volatility increases, it can do so violently.

For example, in the financial market crisis of 2020, the VIX index went from below 14 to over 80 within two months as the S&P 500 fell over 30%. Traders who were short volatility got destroyed during that time period, while traders who were long volatility experienced massive profits.

If you want to profit from contango in the VIX futures, trading strategies such as buying put options on VXX or UVXY provide traders with limited loss potential in the event of a spike in market volatility.

What Happens When VIX is in Backwardation?

The majority of this guide covers contango because it is present in the VIX market a high percentage of the time.

VIX backwardation occurs when the VIX index is above VIX futures contracts, and longer-term futures are at a discount to shorter-term futures.

Backwardation in VIX futures occurs when market volatility is elevated.

Since VIX futures always converge towards the spot VIX over time, VIX futures will appreciate over time if the spot VIX remains above these futures contracts.

For example, if it is February 1st and the VIX is at 50, and the March VIX future is at 40, the March VIX future will appreciate 10 points by its expiration date if the VIX index remains at 50.

That means long volatility ETPs like VXX and UVXY will also appreciate over that period since they track the daily percentage changes of short-term VIX futures.

But market volatility is always changing, and periods of extreme market volatility typically do not last long. Consequently, the VIX market can go from backwardation to contango quickly if the market recovers and volatility falls.

VIX Backwardation Trading Strategies

When backwardation is present, VIX futures and long volatility products like VXX and UVXY all gain value over time if the VIX does not fall drastically.

If VIX backwardation is present and traders believe S&P 500 volatility will remain unchanged or increase further, profits can be made from long volatility trading strategies, including:

 

  • Buying VIX futures
  • Buying VXX/UVXY shares
  • Buying calls on VIX/VXX/UVXY
  • Shorting puts on VIX/VXX/UVXY

These strategies can profit from persistently high market volatility, as the VIX futures will remain in backwardation and steadily appreciate as they converge towards the higher VIX spot price.

However, traders should be cautious with long volatility trading strategies when market volatility is already elevated, especially if it is extremely high (VIX over 50).

Extreme market volatility typically does not last long, which is precisely why long-dated VIX futures will trade at steep discounts to spot VIX during periods of significant market volatility.

Conclusion

Understanding contango and backwardation is key when trading VIX options, futures, and popular volatility products like VXX, UVXY, or SVXY.

The most critical concept to understand is that volatility products are tied to VIX futures, which converge to the VIX index over time.

During normal market conditions, contango is typically present in the VIX futures curve, leading to steady bleed in the values of volatility index futures as they drift towards the lower VIX index.

The result is losses in long volatility positions (long futures, long VIX calls/short VIX puts, long VXX/UVXY).

For traders to profit from long volatility positions when contango is present, market volatility needs to increase quickly, pulling the VIX index and futures higher.

Otherwise, traders can take advantage of the “contango bleed” and profit from short volatility positions as long as market volatility does not surge. Of course, shorting volatility is no easy trade.

At a minimum, I hope this post helped you grasp the complexities of the volatility market, helping you avoid common pitfalls and disastrous trading results that stem from a lack of awareness related to VIX trading.

Next Lesson

Chris Butler portrait

UVXY: What Is It and Is It Worth The Risk?

Posted on by Mike Martin

Last updated on May 4th, 2022 , 05:21 am

The ProShares Ultra VIX Short Term Futures ETF (UVXY) is a great product for traders looking to both speculate and hedge on short-term volatility. Unlike most volatility products, UVXY provides 1.5x leveraged exposure to the daily performance of the S&P 500 VIX Short-Term Futures Index.

Worth noting here is the word “daily.” Over time, because of contango loss (more to come on this) and time decay, UVXY persistently sheds value. It is because of this UVXY is not designed for long-term traders. In both neutral and bullish markets, UVXY will collapse in value. 

Should you trade Proshares Ultra VIX ETF? For most traders, UVXY is not worth the risk. Let’s break down this ETF to see why.

     TAKEAWAYS

  • UVXY tracks the short-term VIX Futures index on a 1.5x leveraged basis.

  • UVXY uses “Swaps” to achieve its 1.5 leverage.

  • UVXY decays in value over time because of “contango.”

  • Contango occurs when an expiring futures contract trades at a premium to the spot price.

  • UVXY charges a very high expense ratio of 0.95%.

What is UVXY and What Does It Track?

As stated in the fund’s prospectus, ProShares UVXY ETF aims to provide investors:

Important to note here is that the UVXY ETF (technically an exchange-traded note ETN) is correlated to VIX Futures and NOT the VIX Index. Is there a material difference here? 

Absolutely!

Though both the VIX Index and VIX futures have a negative correlation to the equity market, huge differences exist. The most important difference is the performance of the two. 

VIX Index vs. VIX Futures (UVXY): Performance

The below image (taken from spglobal.com) shows just how dramatic the performance of the VIX Index and VIX futures deviates over a 9 year period:

VIX Futures vs VIX Index

So why the huge difference?

Spot vs Futures: Rolling UVXY

The VIX Index is a spot index. Unlike VIX futures (which UVXY tracks on a leveraged basis), no underlying products (like shares) trade on spot indices.

This means that the VIX Index product does not need to be “rolled” to a different expiration to stay alive. Though options trading does occur on indices, since there is no tradable underlying security, contracts are settled in cash instead of shares.

Futures indices do indeed offer tradable securities. Since all future contracts expire, they must be “rolled” to the next month to stay alive.

During calm/”normal” market periods, VIX futures contracts often trade at a premium to the VIX Index.

This premium is known as “contango.” Here’s why contango in the VIX futures market causes UVXY to bleed value over time.

UVXY: Contango vs Backwardation

Contango and Backwardation Graph

 

When the VIX futures contracts are trading at a premium to the VIX index, the VIX futures are in contango.

UVXY tracks the daily performance of the two nearest monthly VIX futures, such as February and March in the above example.

 
If the VIX index remains at 15 as time passes, the February and March VIX futures will steadily lose value as they converge to 15 because a VIX futures contract at maturity will be equal to the spot price (the VIX index).
 
And since UVXY tracks the daily percentage change of a mixture of these two contracts that are steadily losing value in this scenario, UVXY loses value.

UVXY in Backwardation

If the VIX futures contracts are trading below the VIX index, then the futures are in backwardation and will gain value as they converge towards the higher VIX index (assuming the VIX index remains elevated over time).
 
In this scenario, UVXY will gain value because it tracks the daily percentage change of a mixture of these two contracts that are gaining value as they converge towards the higher VIX index.

So do we have any idea how fast, or at what rate ETFs like UVXY will decay? Maybe, and that leads us to the VIX Term Structure.

UVXY and VIX Term Structure

Understanding the VIX term structure can help us predict the rate at which products like UVXY will decay. Take a look at the below visual, which shows the historical prices of the VIX futures contracts on April 1st, 2016:

vix contango

We can see the VIX index was trading at 13. We can also see that the VIX futures contract expiring in August is trading at 19.

In this snapshot in time, UVXY would have been tracking the daily performance of the April and May VIX futures, which were at approximately 19% and 32% premiums to the VIX index.

If the VIX index remained at 13 over time, the April and May VIX futures would both fall from their 15.5 and 17.1 levels to 13. Since UVXY tracks the daily percentage changes of these contracts, UVXY would bleed value.

But what actually happened?

Over the following month, the VIX index rose 12%, but UVXY lost 17.4% because the April and May VIX futures were trading at such large premiums to the VIX index and lost substantial value over the 30-day period:

It should also be noted that at the time, UVXY had 2x leverage, tracking 2x the daily percentage change of a weighted basket of these two VIX futures contracts.

For instance, let’s say UVXY was tracking a 50% weighting in the April contract and a 50% weighting in the May contract in the middle of the roll period.

If the April contract gained 10% and the May contract also gained 10% on the same trading day, UVXY would have gained 20%.

Today, the same daily changes in the VIX futures contracts (assuming the same weightings on the trading day in question) would result in a 15% UVXY gain after its leverage was reduced to 1.5x in 2018.

UVXY: Positions and Holdings

The below visual (taken from UVXY’s issuer ProShares) shows the funds current holdings:

ProShares UVXY Holdings

Notice the fund has exposure to both March and April futures.

Why two months? The UVXY ETF attempts to track a 30-day VIX futures contract, but since there’s not always a futures contract with exactly 30 days to settlement, they hold a specific weighting of the nearest monthly contracts that gives them a weighted 30-day portfolio.

Put more simply, if the March contract had 15 days to settlement and the April contract had 45 days to settlement, a 50% weighting in each contract would give them a “weighted 30-day VIX futures contract.”

15 Days to Settlement x 50% Weight = 7.5 Days to Settlement

45 Days to Settlement x 50% Weight = 22.5 Days to Settlement

7.5 + 22.5 = 30 Days to Settlement.

The proportion of front month and next month futures are in a state of perpetual flux. As March settlement approaches, ProShares will increasingly shift its holdings to the April contract, reaching a 100% weighting when the March contract settles.

 
Each day after that, the fund will sell a portion of its April VIX futures and buy some May VIX futures. The process repeats indefinitely.

But what about that short-term swap? This is where the leverage comes into play.

UVXY's 1.5X Leverage: SWAPs

Many savvy investors are familiar with options trading. Options provide traders with great leverage. 

But sometimes these derivatives are not feasible for leveraged funds. 

Instead, swaps are used. 

Swaps are non-standardized contracts. Swaps are exceedingly opaque for this reason. We truly don’t know how ProShares obtains its 1.5x leverage, but the secret is in the sauce of that swap – whatever it may contain!

UVXY: Expense Ratio

Future-based ETFs are notoriously expensive. Why?

All that rolling is costly from both manpower and commission-based perspective. This leads to the current expense ratio for UVXY:

UVXY Fee's

UVXY Expense Ratio

ProShares UVXY  management fee of 0.95% comes in at about twice the average expense ratio of other ETFs.

When added to the cost of contango, UVXY could be a huge drag on your account. 

UVXY: Historical Returns

We said before that UVXY is reserved for short-term traders. Hopefully, the below one-year chart of UVXY will drive that point home. 

UVXY: 1 Year Chart

UVXY Chart.

Source: Google Finance

Let’s take this one step further and look at a 5 year chart of UVXY:

UVXY: 5 Year Chart

Source: Google Finance

So we can all agree that UVXY over the long run is a horrible idea (pending an economic apocalypse).

But UVXY is a leveraged ETF; how does this product compare to unleveraged ETFs (like VXX) that track VIX futures?

UVXY vs VXX vs VIX

The below image compares UVXY to the VIX index as well as VXX. VXX, issued by Barclay’s, is similar to UVXY in that they both track futures on the VIX. However, VXX is not leveraged as UVXY is.

Consequently, VXX will gain less than UVXY in times of increasing VIX futures, and will lose less than UVXY in times of decaying VIX futures.

Let’s see how the performance between these products looks over one year (ending in March 2022).

UVXY vs VXX vs VIX: 1 Year Chart

VIX vs VXX vs UVXY

Source: Google Finance

As we can see, the leverage that UVXY provides has hurt the fund over the long run when compared to the VIX. Additionally, the normally present contango in the VIX futures curve has hurt both VXX and UVXY.

Now seems like a good time to quickly recap three reasons why UVXY is not a good product to trade for more than a day:

3 Reasons UVXY is NOT Worth the Risk

  1. Contango contributes to the massive decay in ProShare’s UVXY leveraged ETF.
  2. UVXY uses swaps to achieve its leverage – leveraged ETFs decay faster than non-leveraged ETFs (VXX), particularly in adverse markets.
  3. UVXY charges a very high management fee of 0.95%.  

When Should you Trade UVXY?

Proshares UVXY ETF (sometimes referred to as an ETN) is best suited for traders who:

1.  Want to speculate on a rise in the price of VIX futures.
2.  Want to hedge equity positions in the event of a market downturn.
3.  Have a very short duration for both speculation and hedging.

Does UVXY Pay A Dividend?

Since UVXY does not hold any equity, this product does not pay a dividend. 

Final Word

Futures-based ETFs are inherently risky. Add leverage to the mix, and you have even more risk. 

I personally only use leveraged ETFs to hedge against imminent market news, such as jobs reports and the release of inflation data. 

ProShares designed UVXY to be held for a very short duration, typically a day only. To see why, revisit one of those charts we looked at above!

If you’d like to learn more about leveraged ETFs, feel free to check out our video below!

UVXY FAQs

UVXY experiences profound contango. Rolling futures in this ETF can result in monthly losses exceeding 5%. 

Both UVXY and SVXY are futures based ETFs. However, UVXY profits during times of heightened volatility and SVXY profits during times of low volatility. 

Traders can purchase UVXY in both the normal market and extended market. To trade UVXY in the extended market, make sure to tag your order with the correct ” EXT” TIF Designation.

UVXY goes up in value during times of heightened volatility. If short-term VIX futures are up 1% in value, UVXY aims to be up 1.5% in value because of its leverage. 

You can hold UVXY for any time period, including overnight. However, holding UVXY for long periods of time is not advised due to contango. 

UVXY is technically an ETN (exchange-traded note), though its issuer, ProShares, refers to it as a ETF (exchange-traded fund).

UVXY Next Lesson

Supplemental Reading

UVXY: It’s Just Not Worth The Risk – Seeking Alpha

UVXY ETF Report: Ratings, Analysis, Quotes, Holdings

Options: Buy to Open vs Buy to Close & Sell to Open vs Sell to Close

Posted on by Mike Martin

Last updated on May 4th, 2022 , 09:23 am

BTO and STO; BTC and STC Options Trading (2)

When placing an options trade, traders have one of four transaction “position types” on the order confirmation box to choose from:

  1. But to Open (BTO)
  2. Buy to Close (BTC)
  3. Sell to Open (STO)
  4. Sell to Close (STC)

On some trading platforms, this box will be pre-selected for you. Other trading platforms give traders the choice to choose whether or not the trade is closing or opening. 

However, regardless of what you choose here, the order will default to the proper opening or closing transaction. 

So why the choice? Sometimes, trades are filled and then allocated to different accounts. This option is mostly reserved for advisors who trade in bulk, and then allocate trades to the proper accounts. 

But since all options traders see this choice, let’s go through every possible type of opening/closing transaction for derivatives. 

         TAKEAWAYS

 

  • All initiating long option trades are marked “Buy to Open” (BTO).

  • All closing long option trades are marked “Sell to Close” (STC).

  • All initiating short options trades are marked “Sell to Open” (STO).

  • Closing short positions in options are marked “Buy to Close” (BTC).

  • Spread trading can involve both Buy/Sell to Open as well as Buy/Sell to Close.

  • Rolling options can involve using contrasting position effect designations (e.g., BTC and BTO).

Buy to Open (BTO): Long Call and Put Options

If a trader is going long a call or put option, that order should be designated as “Buy to Open”.

Buy to Open: Long Call Option

Call options are bullish trades that bet on a rise in the value of an ETF, index, or stock price. Long call options need the underlying asset to rise significantly in value to profit. 

Long Call

Traders establishing an opening trade in a long call option should tag that order “Buy to Open” (BTO).

Buy to Open (BTO) Call option

Buy to Open: Long Put Options

Put options are bearish trades that profit when the underlying asset decreases significantly in value.

Long Put Chart

As with call options, all opening long put option positions should be tagged “Buy to Open” (BTO). 

Buy to Open (BTO) Put Option

Sell to Open (STO): Short Call and Put Options

Just as with stock, options can be both bought and sold. A short option position has the exact opposite profit/loss profile as its long counterpart. 

All initiating short option positions should be tagged “Sell to Open” (STO).

Sell to Open: Short Call Option

The short call option is a neutral to bearish options trading strategy with unlimited loss potential. 

Short Call Option Graph

All initiating short call option positions need to be tagged “Sell to Open”. Regardless of whether you’re buying or selling, if a trade is initiating, that trade needs to be marked “opening”. 

The below image shows how selling call options to open on Google should be setup. 

Sell to open short call

Sell to Open: Short Put Option

The short put option is a neutral to bullish options trading strategy with great loss potential.

Short Put Option Graph

All traders initiating a short put option position need to tag their order “Sell to Open” (STO). The below images shows the order confirmation box for a short put position in Tesla (TSLA).

tsla sell to open put

So far, we have covered the basic “position types” used for initiating option orders.

When closing option trades, the exact opposite (“To Close”) designation is used. Let’s look at a few examples next!

Sell to Close (STC): Exiting Long Options

Whenever trading out of a long option position, that order should be tagged “Sell to Close”. Let’s start off by looking at how closing a long call option should be setup.

Sell to Close: Exiting Long Call Option

When selling a long call option, you are conducting a “Sell to Close” (STC) transaction. 

The below image shows how closing a pre-existing call option on GOOGL should appear on your order confirmation page:

buy to close (BTC) short call option

Sell to Close: Exiting Long Put Position

The same STC position effect is true of exiting long put options. The below image shows the proper setup for closing a long GME put option. 

GME sell to close put

Buy to Close (BTC): Exiting Short Options

All short option positions are exited in a “buy to close” (BTC) transaction. Let’s take a look at the proper setup for exiting a short call in AAPL first:

Buy to Close: Exiting Short Call Option

If a trader were short the 167.5 strike price call on AAPL and wanted to close that option out before it expired, that trader would place a “buy to close” order. This order would look similar to the one below.  

buy to close short aapl

Buy to Close: Exiting Short Put Option

Exiting short put options would have the same setup as exiting long call options. All short options are marked “Buy to Close” when buying back.

The below image shows how closing a short 417 strike price put option in SPY expiring on March 18th should appear:

buy to close example short spy put

Buy to Open vs Sell to Open: Spreads

Spread trading can involve buying and selling different options in one transaction. 

This may require you to mark different legs of the trade with different position effect designations.

Consider a vertical spread in AAPL that involves both buying and selling options:

BTO vertical spread options

Since we are both buying and selling initiating options here, both legs should be marked “To Open”.

The same is true for the closing transaction: both sides must be marked “To Close”.

Rolling Trades

Sometimes, trades don’t go our way. When this happens, we may want to roll our call or put option out to a different expiration date. This is an alternative way to opening a new position. 

Let’s say we are long a call option on NFLX. Time decay (or theta) has worked against us, and our long position has declined in value from the price we bought it for.

If we are still bullish on NFLX, we could roll that trade out to a different expiration. This would involve using both the “Buy to Close” and “Buy to Open” designation:

Order Confirmation: Other Information

In addition to the position effect, a few other vital designations must be set in the trade confirmation box before a trade is placed. 

Time-in-Force (TIF) Designation:

Time in Force (TIF) tells your broker the time and duration you want your order working for. These can include:

  • DAY (day order)
  • GTC (good till canceled)
  • EXT (Extended market)
TIF order types

Option Order Type:

In addition to TIF, an option order type must be selected. These include:

Final Word

Most trading platforms choose the position effect of your order for you. But even if you have to choose this on your own, chances are your broker will automatically change this to the correct buy/sell designation should you choose the wrong one. 

On tastyworks, this work is already done for you. Just another reason why we use tastyworks as our preferred broker!

Position Effect FAQ

The “sell to open” designation should be used for initiating trades only. This can include selling a single option to open, or selling the short component of a vertical spread. 

All initiating trades should be marked “To Open”. Long option positions are established by marking the order “Buy to Open”; short option positions are established by marking the order “Sell to Open”.

Buying to close a pre-existing short put position can be accomplished by either creating the opposite order of your initiating sell trade, or by finding the option you wish to buy back on the options chain. 

The best time to sell to close a call or put option is when that option breaches your pre-established lower limit or upper bound. Having these prices in place before a trade is entered can help take emotion out of trading. 

Next Lesson

Additional Resources

How to Trade Options: Buying or Selling Call and Put Options

Buy to Open Definition – Investopedia

 

Master Option Order Types: 7 Complete Guides

Posted on by Mike Martin

Last updated on April 27th, 2022 , 07:46 am

Option Order Types

Order Types

An introductory guide to option order types. Get started here!

Read More!

Market Order

Market Order Options

Markets order are filled immediately regardless of price. In both illiquid stocks and options, market orders can lead to horrible fills. 

Always avoid market orders on the market open/close!

Read More!

Limit Order

Option Limit Order

In options trading, limit orders are the only way to go. Why? They set an upper bound on the maximum debit you are willing to pay and a lower bound on the minimum credit you are willing to receive. 

The downside? Fills aren’t guaranteed!

Read More!

Stop-loss

Stop Loss Order

A stop-loss order is simply a market order in disguise. Your broker holds these orders until the stop price is breached. They are then sent to the market makers. In the eyes of exchanges, stop-loss orders are the same as market orders.

Read More!

Stop-Limit

stop limit order options

A stop-limit order is a great alternative to the stop order. Unlike a stop-loss order, the stop-limit order triggers a limit order. 

However, if the limit price is breached, stop-limit orders may never get filled.  

Read More!

TIF Orders

tif order types: stocks options

So now you know the order types. But for how long do you want that order working, and during what market period? Read all about time-in-force (TIF) order types here!

Read More!

BTO vs BTC

BTO and STO; BTC and STC Options Trading (2)

The “position effect” box lets us choose whether our order is opening or closing. Which is right for your trade?

Read More!

Supplemental Video

Next Lesson

Here’s What Happens When Options Expire In-The-Money

Posted on by Mike Martin

Last updated on March 21st, 2022 , 03:38 am

In The Money Option at Expiration

In-the-money options can pose a significant risk to traders going into expiration. This is unlike out-of-the-money options, which expire worthless post expiration and require no action. 

It is almost always best to trade out of in-the-money options before the closing bell on the expiration day.

If no action is taken, both long options and short options are converted into 100 shares of stock. The cost and risk of this stock can be much greater than the cost and risk of the original option position. 

However, not all in-the-money options are exercised and thus assigned into stock. Let’s first explore a few of the key differences between European and American Style Options. 

       TAKEAWAYS

  • It rarely makes financial sense to let an in-the-money option be exercised or assigned.

  • European style options (indices) are cash-settled; no transference of stock takes place.

  • American style options (ETFs and equities) are settled via physical delivery; a transfer of stock takes place.

  • Long in-the-money calls are exercised to +100 shares of stock; short calls are assigned -100 shares of short stock.

  • Long in-the-money puts are exercised to -100 shares of stock; short puts are assigned +100 long shares of stock.

  • If an option has intrinsic value at expiration, it will be assigned/exercised. 

In-The-Money European Options at Expiration

Options that trade on indices such as SPX and NDX are styled in the European fashion. Here are a few characteristics of European Style Options:

  • European Options Don’t Offer Stock
  • European Options Can Not Be Exercised Early
  • European Options are cash-settled.

Since no stock trades on European options, how can in-the-money European style options be settled in stock?

They can’t. A simple transfer of cash takes place at expiration between the long and short parties. Let’s look at an example:

European Style Option Example

SPX 4,300 Call

➥ Index Value at Expiration: $4,305

➥ Call Value at Expiration: $5

For the above trade, the long party owns an in-the-money call worth $5 post-expiration.

The short party must therefore deliver $500 cash to make good on the contract. If this were an American-style option, a transfer of 100 shares of stock would take place at the call strike price of 4,300. Let’s look at American style options next!

In-The-Money American Options at Expiration

All options are either European or American style. As we learned above, European-style options are generally indices. 

American style options are everything else. This includes options on ETFs and equities. Here are a few characteristics of American style options:

  • American Options Do Offer Stock
  • American Options Can Be Exercised Early
  • American Options Are Settled via Physical Delivery of Stock

Since American-style options are settled via an exchange of stock, traders both long and short in-the-money call and put options need to take action by expiration to avoid being assigned/exercised on the stock. 

Let’s take a look at an example.

American Style Option Example

SPY ETF $430 Call

➥ ETF Value at Expiration: $432

➥ Call Value at Expiration: $2

An expiration, only intrinsic value exists in options. Since both the risks of time (theta) and implied volatility no longer exist, extrinsic value is discounted completely from the options price. 

Read! Intrinsic vs Extrinsic Value in Options Trading

extrinsic intrinsic value

Our SPY option is in-the-money by $2, therefore its (intrinsic) value is $2.

Now if you are long this call, wouldn’t it make sense to exercise it? The call gives you the right to purchase the stock at $430/share. This is a better price than the current SPY market price of $432.

In this scenario, the long would indeed exercise their right, and the short would be forced to deliver 100 shares:

  • Long Call Ending Position: +100 shares at $430/share
  • Short Call Ending Position: – 100 shares at $430/share

In-The-Money Options and Assignment/Exercise Cost

In the above example, we showed the net post-expiration position for both the long call and the short call. 

The long call owner exercised his call (valued at $2, or $200 taking into account the multiplier effect) into 100 shares of stock. How much will this stock cost? $430 x 100 + $43,000.

That’s a lot of money. If a trader doesn’t have the funds to hold this position the next day when the stock appears in their account, their broker will put them in a margin call. 

The same is true with the short party. If they can’t hold -100 shares of SPY stock (valued at 43k) their broker will liquidate the account. 

Let’s next go through the process of what happens to in-the-money American style options at expiration.

In The Money Long Call at Expiration

  • Long call options that are in the money by 0.01 or more on expiration will be automatically exercised by a broker, resulting in +100 shares of long stock.

In The Money Short Call at Expiration

  • Short Call options that are in the money by 0.01 or more on expiration will be automatically assigned by a broker, resulting in -100 shares of short stock.

In The Money Long Put at Expiration

  • Long put options that are in the money by 0.01 or more on expiration will be automatically exercised by a broker, resulting in -100 shares of short stock.

In The Money Short Put at Expiration

  • Short put options that are in the money by 0.01 or more on expiration will be automatically assigned by a broker, resulting in +100 shares of short stock.

Check Out Our Video On Option Expiration Here!

Should I Exercise My In The Money Option at Expiration?

The vast, vast majority of the time, it does not make sense to allow long in-the-money options to be exercised or assigned.

Personally, I have never done this. Why?

Risk! As we said before, long options generally have less net risk than long stock. We have no idea where a stock is going to be trading on the day it opens post-expiration.

Let’s say you are long an AMZN call going into expiration. Right before the bell, it’s trading at $2. Your downside risk here is $200.

But if you choose to exercise that option, you must buy 100 shares of AMZN. The current cost of 100 shares of AMZN? About $300,000!

That’s a lot of risk! There is hardly ever a reason to exercise an option. 

Sometimes, covered call positions allow their short call to be assigned, but they already have 100 long shares of stock, so the risk is offset.

It rarely, if ever, makes sense to exercise (or be assigned) on naked call and put options going into expiration. In addition to the market risk, there are also additional exercise assignment fees that go along with holding in-the-money options through expiration. 

Simply trade out of the position before the bell and you’ll sleep much better. Trust me!

Is My Option In The Money?

Determining moneyness is quite simple. 

option moneyness chart calls and puts
  • Call options are in the money when the strike price is below the stock price.
  • Put options are in the money when the strike price is above the stock price.

In-The-Money Options at Expiration FAQ's

You can sell an option at any time before the closing bell on expiration day. This includes expiration day itself. It is best to not wait until the final seconds of trading to trade out of options. If technology fails, you may find yourself in a bit of trouble. 

Yes, you can exercise options on expiration day. You can even choose to exercise options (or not exercise them) after the market closes on expiration day. The cutoff time for exercising an option is 4:40pm CT.

Brokers automatically exercise in-the-money options at expiration. You can, however, communicate to your broker that you do not want to exercise an option. If your broker is not informed, you will be automatically exercised on your long call/put options that are in the money by 0.01 or more. 

When a long call expires in-the-money (ITM), a broker will automatically exercise the option. This will ultimately result in +100 shares of long stock. 

Next Lesson

Additional Resources

What Happens When Options Expire | tastytrade

Option Expiration – Investopedia

Long Call vs Short Call: Option Strategy Comparison

Posted on by Mike Martin

Last updated on March 1st, 2022 , 09:08 am

Long Call Definition: The long call is a low probability bullish options trading strategy with unlimited profit potential.

Long Call

Short Call Definition: The short call is a high probability bearish options trading strategy with unlimited risk. 

Short Call Option Graph

As with stock, options can be both bought and sold. The profit/loss profile for a long call is the polar opposite of a short call. 

Before we dive into comparing the short and long call options, it is necessary to understand the fundamental difference between long and short options.

  • Long option positions give the owner the right to buy or sell a security (call & puts) at a specific price (strike price) on or before a specific date (expiration date).
  • Short option positions have no rights and must stand ready to either sell stock (call options) or buy stock (put options) when and if the long party exercises their right. 

            TAKEAWAYS

  • The long call is a low-probability bullish strategy with limited risk.

  • The short call is a high-probability bearish/neutral strategy with unlimited risk.

  • Long calls profit when the underlying moves up significantly in value.

  • Short calls profit in both neutral and bearish markets.

  • The maximum loss for long calls is the debit paid; the maximum loss for short calls is infinite.

  • The maximum profit in long call options is unlimited; the maximum profit in short calls is the credit received.
Long Call Short Call

Market Direction

Bullish

Neutral and Bearish

When To Trade

Best for traders very bullish on a security

Best for traders who believe a security will either be neutral or fall in value.

Maximum Profit

Unlimited

Credit received

Maximum Loss

Entire debit paid

Unlimited

Breakeven

 Strike Price + Debit Paid.

Strike Price + Credit Received.

Time Decay Effect

As time passes, and both implied volatility and stock price stay the same, a long call will persistently shed value. 

As time passes, and both the implied volatility and stock price stay the same, a short call option will shed value – which is desirable for short calls. 

Probability of Success

Low

High

Long Call vs Short Call: Key Differences

When it comes to the profit/loss profile, the long call is the exact opposite of the short call. Before we dig into the individual strategies, let’s explore a few of the fundamental differences between the long call and the short call. 

Long Call vs Short Call

1.) Long Calls vs Short Calls: Trade Cost

Long Call Option: Whenever you buy an option, the cost of that option will be the cost of the trade. If a long call option is trading at 3.50 and you purchase this option, a debit of $350 will be deducted from your account.

When buying options, the true cost of the trade is calculated by moving the decimal of the quoted price two places to the right. This is because of the multiplier effect, which gives options a 100×1 leverage. 

Short Call Option: The trade cost of selling call options is a little murkier than buying call options. 

Whenever you sell naked options, a credit is made to your account. Since there is no upfront debit paid, and the trade does indeed have risk, your broker will require that funds be held in margin. 

At tastyworks, this margin requirement is the greater of:

short call margin requirement

2.) Long Calls vs Short Calls: Maximum Profit

In long calls, the profit is unlimited. There is no upside cap on how high a stock can run, therefore, the profit potential in a long call is infinite

In short calls, (as with all short options) the maximum profit is always the credit received. You can never make more than the initial credit received. 

3.) Long Calls vs Short Calls: Maximum Loss

In long calls, the maximum loss is limited to the initial debit paid for the call option. Since options can never fall below zero in value, the maximum loss for long calls is the upfront debit paid. 

In short calls, the maximum loss is unlimited. We mentioned earlier that the maximum profit on a long call is unlimited. Therefore, the maximum loss on short calls must be infinite. 

4.) Long Calls vs Short Calls: Breakeven

➥ The long call breakeven is Strike Price +  Debit Paid.

➥ The short put breakeven is Strike Price + Premium Received.

5.) Long Calls vs Short Calls: When to Trade?

Long calls are best suited for bullish investors who believe the underlying will go up significantly in value. If a stock goes up just a little or stays the same, long calls decay in value.
 
Short Calls are reserved for traders who believe a stock is not going to move by very much over the duration of an options life. Short calls can profit in any market, including bearish, neutral, and minorly bullish markets. 

Long Call Trade Example

In this example, we are going to look at an at-the-money call option (strike price near the stock price). Here are the details of our trade:

‣ Initial Stock Price: $105

‣ Call Strike and Expiration: 105 call expiring in 31 days

‣ Call Purchase Price:$3.40

‣ Call Breakeven Price: $105 call strike price + $3.40 debit paid for call = $108.40

‣ Maximum Profit Potential: Unlimited

‣ Maximum Loss Potential: $3.40 call purchase price x 100 = $340

Long Call Trade Results

Call vs DTE

In this long call example, the stock price never traded higher than the call’s breakeven price. Additionally, the stock price also never fell significantly below the call’s strike price. As a result, our call experienced a slow decay, which lead to losses.

However, there were opportunities for us to close this call for a profit.

To close a long call position before expiration, a trader can simply sell the call option at its current price. 

Short Call Trade Example

In this example, we are going to look at an out-of-the-money short call. Here are the details of our trade:

‣ Initial Stock Price: $119.94

‣ Call Strike and Expiration: 125 call expiring in 71 days

‣ Call Sale Price: $1.52

‣ Call Breakeven Price: $125 call strike + $1.52 credit received = $126.52

‣ Maximum Profit Potential: $1.52 credit received x 100 = $152

‣ Maximum Loss Potential: Unlimited

Let’s next see how this short call performed!

Short Call Trade Results

short call vs stock

In this short call example, the stock price gradually increased in price from $120 to $126. Our short 125 call never experienced material losses during this time.

With 11 days to expiration, the stock price was above the short call’s strike price of $125, and the position had small profits.

Time decay was able to fight against any directional losses in this trade.

The decrease in the call’s price from its initial sale price of $1.52 offered us the opportunity to buy back the call for a profit before the option expired. At 40 days to expiration, the 125 call’s price fell below $0.75, which represents a $77 profit for the call seller at that moment. 

If we held this option until expiration, the position would expire worthless. Why? The stock price was below the short call’s strike price. 

In this trade, our full potential maximum profit of $152 was realized. 

Long Call vs Short Call FAQ's

In options trading, “long” implies either ownership of a single option(s), or a net debit transaction. The term “short” implies the sale of an option(s), or a net credit transaction. 

A naked call is a neutral to bearish strategy with unlimited risk; a long call is a bullish strategy with only premium risk. 

A “call” option is a broad term used to describe a security. You can both buy and sell call options. When a trader purchases a call option, they are “long” that option; if a trader instead sells a call option, they are “short” that option. 

Long calls generally need the underlying security to rise substantially in value in order to profit. Because of time decay (theta), most out-of-the-money call options expire worthless, resulting in a maximum loss scenario. Maximum profit in long calls, however, is infinite. 

The total loss potential on a long call is the debit paid. This scenario will occur if the stock price is trading below the strike price on expiration. From a total risk perspective, long calls are safer than short calls. 

Selling naked calls is the riskiest options trading strategy. Since a stock has no upper bound, short call options have infinite risk. 

Long Call vs Short Call Video

Long Call Tutorial

Short Call Tutorial

Next Lesson

Additional Resources

Long Position vs. Short Position: Key Differences – Investopedia