Mike Martin

What Is a Cash-Secured Put? Get Income or Cheap Stock

Posted on March 28, 2022May 6, 2022 by Mike Martin

Last updated on May 6th, 2022 , 03:49 am

The cash-secured put is a risk-defined options trading strategy that involves the sale of a put option while holding funds on reserve to purchase the stock if/when assignment occurs.

The cash-secured put (also known as the cash covered put) options strategy is attractive to investors for two reasons:

1.) The cash-secured put provides investors with a steady stream of income.

2.) When/if assigned, cash-secured puts allow investors to purchase desirable stocks at a discount.

The cash-secured put has a lot in common with the short (naked) put, with one major exception: the seller of cash-secured puts does not fear the stock falling in value, as it is their intent to purchase the stock at a discount via the exercise/assignment process.

In an environment of constant volatility and price, options decay in value. This time decay, known as “theta” is advantageous to both short call and put options.

Let’s first break this strategy down by looking at its profile.

TAKEAWAYS

The cash-secured put is a neutral to bullish options trading strategy.
In order for this trade to be “cash-secured”, the cost of the trade will be the cost to purchase 100 shares of the underlying stock at the strike price of the put sold.
The cash-secured put is an investment strategy that allows an investor to buy an attractive stock at a lower purchase price.
If/when assigned, the short put will be replaced by 100 long shares of the underlying stock/ETF.
Traders who are very bullish on an underlying
would be better off by simply buying the stock outright.

	Cash Covered Put
Market Direction	All Market Directions (depending on trade intent)
Trade Setup	Short 1 ATM/OTM Put Option
Maximum Profit	1.) On the short put, max profit is the credit received. 2.) If assigned to stock, max profit is unlimited.
Maximum Loss	1.) On the short put, max loss is strike price minus the premium received. 2.) If assigned to long stock, the max loss is unlimited.
Breakeven Point	Strike price minus the premium received for the put.
Trade Cost (Margin)	Cash Account: (strike price) × (number of contracts) × (option multiplier) Margin Account: Varies by broker (lower than cash account)

What are Cash Secured (Covered) Puts?

The cash-secured put strategy has two components:

1.) Selling a put option contract

2.) Setting enough money aside to purchase stock at the strike price of the put should assignment occur.

Determining the “moneyness” state of the put option you wish to short is subjective. Generally speaking, the strike price of put options sold in this strategy will be either:

1.) At-The-Money

2.) Out-Of-The Money

The cash-secured put is unique in that most traders of this strategy want their option to be assigned. This allows the stock to be purchased at a lower cost basis.

However, even if assignment does not occur, the income from selling the put will still be collected, resulting in a win-win scenario.

For example, if Ford stock (F), is trading at $15/share, and an investor wished to buy this stock at $13/share, that investor could sell the $13 put option at a later expiration cycle.

If the stock closes above $13/share at expiration, the option will expire worthless.

If the stock is trading below $13 at expiration, the short put will be assigned, and that investor will purchase 100 shares of F stock at the lower price of $13/share.

Cash Secured Put Risks

Risk #1:

We mentioned before that the cash-secured put is often a “win-win” trade. This does not mean that there is no risk in this options strategy.

Most of the time, traders utilize this strategy when they want to purchase a stock at a discount from its current market price. If the stock price remains neutral, a trader will receive income from the option(s) sold. If the stock price declines below the strike price by expiry, that trader will purchase the stock at a better price.

But what if the stock is neither neutral or bearish, but bullish?

A trader could very well miss out on the price appreciation of a stock while waiting for it to fall in value, collecting only a relatively small amount of income from the put option sold.

Risk #2

The second risk that the cash-covered put introduces pertains to the option itself. If a trader sells a $15 strike put, but that stock crashes to $10 in value, that trade will result in significant losses. Cash-secured puts are rarely sold on stocks that experience high volatility or this reason.

Sure you’ll buy the stock for cheaper, but you’ll also lose a ton of money on the option. The “wait-and-see” approach is best for more volatile stocks.

But enough theory, let’s see the cash-covered put in practice!

Dividend Alert! Options do not pay dividends. Short put options, though bullish in nature, will miss out on the dividend paid by companies.

Cash Secured Put Trade Example

In this trade example, we are going to look at a cash-secured put on GoPro (GPRO). I prefer to use this strategy on cheap stocks. The cost of the trade is low, and if assignment occurs, it won’t eat up all your cash to hold the 100 shares.

Trade Details:

➥ GPRO Stock Price: $8.40

➥ Put Option Strike Price: 8

➥ Credit Received: 0.25

➥ DTE (Days to Expiration): 35

➥ Breakeven: $7.75 (Strike Price – Premium)

➥ Maximum Potential Profit: 0.25 ($25)

➥ Maximum Potential Loss: $775 (Strike Price 8 – Premium 0.25)

We are next going to examine this trade through two different outcomes; one will be a desirable outcome, the next outcome will be less than desirable.

Cash-Secured Put: Outcome #1

Trade Details:

➥ GPRO Stock Price: $8.40 –> $7.50

➥ Put Option Strike Price: 8

➥ Put Value: 0.25 –> 0.50

➥ DTE (Days to Expiration): 0

In this trade outcome, the price of GPRO has fallen in value below the strike of our short put. If at the expiration date the stock price is below the short put strike, you will be assigned. The below image shows the exercise/assign process:

Assignment/Exercise Process

Here are the sequential steps that will happen to our GPRO trade if our option is in-the-money at expiration.

1.) The long party will exercise their long put option and receive -100 shares of stock; the short party (us) must therefore deliver this stock at $8/share.

2.) Our short option is replaced by 100 long shares of GPRO stock for a cost of $800 (the true cost of this trade is $775 since the trade took in $25 in premium).

3.) If funds are not available to hold this stock, an account will be either placed in a margin call or liquidated.

For cash-secured puts, the third outcome rarely happens. Why? Cash-secured means that a trader already has the funds placed on reserve to hold the stock. They are anticipating this to happen.

Cash-Secured Put: Outcome #2

Trade Details:

➥ GPRO Stock Price: $8.40 –> $10

➥ Put Option Strike Price: 8

➥ Put Value: 0.25 –> 0

➥ DTE (Days to Expiration): 0

In this trade outcome, the stock has risen well above our short strike price at expiration. This means there is zero chance of assignment.

The good news? This trade collected the full premium of 0.25 ($25).

The bad news? We would have made a lot more money if we had just purchased the stock!

At the time of trade origination, the stock was trading at $8.40. At expiry, it was trading at $10/share.

Had we just bought 100 shares of stock initially, we would have made $160 ($1.60 x 1 00) which is significantly less than the $25 we actually made.

How Much Money Do You Need for a Cash Secured Put?

Cash-Secured Puts Trade Cost: (strike price) × (number of contracts) × (option multiplier)

For any account type, trading cash-secured puts is a costly endeavor.

Cash-covered puts are backed 100% by cash. The cost of the trade is the cost to purchase the stock at the strike price. This means that if a stock plummets to zero, a cash-secured put trader already has those funds in their account to cover these losses. Let’s look at two examples:

➥AMZN: Short 2700 Put for $2

So in this scenario, we must have the cash to purchase 100 shares of AMZN stock at $2,700/share. That’s a cost of $270,000.

We can reduce the credit from this cost, but that credit is very small in the scheme of things, resulting in a true cost of $269,800

One of the great disadvantages of the cash-secured put is opportunity cost: what else could you be doing with that money? 270k is a lot of money to have on the sidelines! This is particularly true when you factor in the average return of the S&P 500 is over 10%/year.

That’s why cash-secured puts are usually sold on cheaper ETFs and stocks:

➥NOK: Short 4 put for $0.25

Sure you can only make $25 here, but the cash requirement for this cheap trade is only $400, or $375 when taking into account the option premium already received.

Is a Covered Put the Same as a Cash Secured Put?

The cash-secured put is NOT the same strategy as the covered put.

While the cash-secured put is simply a short put option, the covered put option strategy consists of:

100 Short Shares of Stock
Short One Put Option

The product of these two positions makes the covered put a bearish options strategy.

The cash-secured put is a neutral/bullish options strategy.

Additionally, the covered put strategy has unlimited risk, while the cash-secured put has defined risk.

The below image shows the profit and loss of a covered put trade at expiration.

Covered Put Chart

Are Cash Secured Puts a Good Strategy?

So is the cash-secured put a good strategy? Like everything in options trading, that depends on the performance of the underlying!

If you are neutral to bearish in the short term, but bullish in the long-term, the cash-secured put is a great strategy to purchase an attractive stock or ETF at a discount.

If you are bullish in the short-term, you best bet is to avoid this strategy and simply purchase the stock.

Cash-Secured Put + Covered Call Strategy = The Wheel

Some traders like to utilize both the cash-secured put trade and covered call options strategy in sequential order. This is known as “The Wheel” options trading strategy.

The Wheel strategy involves always being short an option. Once the short put is assigned, a trader would then proceed to sell a call against the long shares.

Here’s how that process works:

Can I Sell Put Options in My IRA?

The cash-secured put is a risk-defined trade and therefore permittable in both IRA accounts and cash accounts.

However, just because the trade is allowed in these account types does not necessarily mean your broker will permit them.

Because of the risks that options trading introduces, many brokers limit or outright ban options trading in retirement accounts.

However, a few trader-focused brokers, like tastyworks, allow options trading in IRA accounts.

Cash Secured Put vs Short Put

The cash-secured put is essentially the same trade as the naked put. The only difference is the cost of the trade.

Consider the cost of the below two short puts trades in FB, where one is done in an IRA account and the other done in a margin account:

Cash-Covered Put: Margin Account

Cash-Covered Put: IRA Account

As we can see, the cost of this trade is significantly higher in IRA and cash accounts than margin accounts. Why? IRA accounts don’t allow you to trade options on margin.

One of the greatest risks that come with the cash-covered put is opportunity cost. What else could you be doing with that 20k while you are waiting to collect a small premium?

Cash Secured Puts FAQs

How do you close out a cash secured put?

To close a cash-secured put, simply create the opposite order that was used to initiate the trade. If no action is taken and the cash-secured put is out-of-the-money at expiration, the short put will expire worthless. If the short put is in-the-money at expiration, the short put will be assigned 100 long shares of stock.

What happens if you sell a put and the stock goes up?

If the stock on which a put is sold increases in value, a short put option will decline in value, resulting in profits. If the stock is above the strike price of the put sold by expiration, the put option will expire worthless.

Are cash secured puts safe?

The cash-secured put is a relatively safe strategy. At trade initiation, the full cost of the trade, or the maximum loss potential, is staked by the investor. This makes the cash-secured put a defined-risk trade.

Next Lesson

Long (Bull) Call Ladder Options Strategy: Visual Guide

Posted on March 24, 2022April 7, 2022 by Mike Martin

Last updated on April 7th, 2022 , 07:05 am

TAKEAWAYS

The long call ladder (AKA bull call ladder) is comprised of a traditional long call spread with an additional out-of-the-money call sold.
Maximum loss on the long call ladder strategy is infinite.
Maximum profit for the long call ladder spread is Middle Short Strike Price – Strike Price of Long Call – Total Debit Paid.
Max profit occurs when the underlying security is trading between the strike prices of the two calls sold.
Due to the 1×2 long call to short call ratio, the margin is very high for all ladder trades.

The long call ladder (also known as the bull call ladder), is a moderately bullish options trading strategy.

The long call ladder has a lot in common with the bull call spread (long call spread), with a few very important differences.

The chief distinction between these two strategies lies in the risk involved. While the bull call spread is a defined risk strategy, the bull call ladder has unlimited risk.

This unlimited risk lay in the structure of the ladder strategy, which consists of one long call and two short calls. Whenever you have unhedged calls, your risk is infinite.

Let’s break the strategy down!

Bull Call Ladder Profile

	Long Call Ladder
Market Direction	Moderately bullish
Trade Setup	Long 1 ITM Call Short 1 ATM Call Short 1 OTM Call
Maximum Profit	Middle Short Strike Price – Strike Price of Long Call – Total Debit Paid. Occurs when the price of the underlying asset is trading between the strike pries of the two short calls at expiry.
Maximum Loss	Maximum Loss #1: When stock is below long call strike price at expiration, max loss is net debit paid. Maximum Loss #2: When stock rallies beyond the highest strike price sold, max loss is infinite
Breakeven Point	1.) Upper Breakeven: Upper Strike + Middle Strike – Lower Strike – Premium Paid 2.) Lower Breakeven: Long Call Strike Price + Total Debit Paid

Bull Call Ladder vs Bull Call Spread

The best way to understand the ladder strategy is by comparing it to the traditional bull call spread.

The bull call spread is a bullish, defined-risk, limited profit options strategy. The below graph shows the profit/loss profile for this trade at expiration:

The bull call spread consists of two call options:

Long 1 Call Option at Lower Strike Price
Short 1 Call Option at Higher Strike Price

Since we are both long a call and short a call option in the same expiration date cycle, this strategy has defined risk: the most we can lose is the debit paid to enter the trade.

But what if you believed a stock was indeed going to go up, but not past a certain level? Couldn’t you sell an additional call at this level in order to generate a little extra income from the trade?

In options trading, you can do whatever you want. You can combine as many calls and puts and expiration cycles as you desire.

So what would this graph look like if we decided to add an extra short call at the end of this trade?

Long Call Ladder Visualized

The below image shows a traditional bull call spread with an extra short call added at the tail end. The result? The long call ladder (or bull call ladder).

Long 1 Call Option at Low Strike Price
Short 1 Call Option at Middle Strike Price
Short 1 Call at High Strike Price

I like to think of the bull call ladder as the greedy man’s long call spread. If you are not content with the maximum profit from the original call spread (Strike Price of Short Call – Strike Price of Long Call – Net Premium Paid) you could sell an extra call.

This third short call must my further out-of-the-money than the first short call sold.

As long as the stock stays between the strike prices of your short calls, you will achieve both the maximum profit from the original spread (equation above) and the credit received from that extra out-of-the-money call you sold.

The downside? Your risk is now infinite, as illustrated in that downward-sloping red arrow in the above chart.

Let’s take a look at an example next.

Long Call Ladder Trade Example

In this example, we are going to look at a long call ladder on Apple (AAPL) stock. Here are our trade details.

AAPL Long Call Ladder:

AAPL Stock Price: $170
Days to Expiration: 9
Long Call Strike/Debit: 170/$2.95
Short Call #1 Strike/Credit: 175 / $0.96
Short Call #2 Strike/Credit: 180 / $0.27
Net Debit: (2.95-0.96-0.27) = 1.72
Lower Breakeven: $171.72
Upper Breakeven: $183.28
Max Loss: Infinite
Max Profit: $328

So we bought the 170/175 call spread for $1.99 (2.95-0.96), then tacked on an extra short call for 0.27. This extra credit received reduced the cost of our trade by 0.27, bringing the new trade debit down to $1.72. Don’t get too overwhelmed by the numbers.

Our maximum profit here is simply the width of the traditional call spread (5 points), minus the net debit paid (1.72). This gives us 5 – 1.72, or maximum profit potential of $3.28.

Since we have a naked short call, our maximum loss is infinite on the upside, but limited to the cost of the trade on the downside.

To help better understand our trade, let’s analyze it visually:

As we can see, we will achieve maximum profit when AAPL is trading between about 175 and 180 on expiration.

For breakeven, we can expand these bounds to $171.72 and $183.28.

Let’s fast-forward to expiration day and see how our trade did!

Winning AAPL Long Call Ladder at Expiration

AAPL Stock Price: $170 –> $175
Days to Expiration: 9 –> 0
Long Call Strike/Debit: 170/$2.95 –> $5
Short Call #1 Strike/Credit: 175 / $0.96 –> $0
Short Call #2 Strike/Credit: 180 / $0.27 –> $0
Spread Value (5 + 0 + 0) = 5

If on expiration day at the close AAPL is trading at $175, we will have achieved maximum profit on the trade of $328. Why?

Our long 170 call has increased in value from $2.95 to $5. That’s a profit of $205. Additionally, both of the calls we sold expired worthless (one was at-the-money at expiration, which we will call worthless for simplicity). The credit we received for these calls was $0.96 + $0.27. That gives us a credit received of $1.23, or $123.

So what is a profit of $205 plus a profit of $123? $328.

But what if this trade didn’t go our way? What if AAPL kept rising inexorably in value? Let’s check out that trade outcome next.

Losing AAPL Long Call Ladder at Expiration

We said before that the long call ladder is a moderately bullish options trading strategy. This next hypothetical trade outcome will show why. Here, AAPL has risen in value to $190/share in value on expiration day.

AAPL Stock Price: $170 –> $190
Days to Expiration: 9 –> 0
Long Call Strike/Debit: 170/$2.95 –> $20
Short Call #1 Strike/Credit: 175 / $0.96 –> $15
Short Call #2 Strike/Credit: 180 / $0.27 –> $10
Spread Value (20 – 15 – 10) $-5

Traditional bull call spreads are great because you always know your maximum loss scenario – the total debit paid. With long call ladders, this can be much more complicated – and risky.

In this trade example, the short options in our trade have increased significantly in value. If we never added that extra 180 short call, we would have achieved a maximum profit on the traditional call spread component of our trade of $5 ($20-$15 = $5 profit).

But we did indeed sell that extra call. Its value at expiration was $10. That $10 must be subtracted from our profit of $5 on the call spread. The result is a negative spread value of $-5 on expiration. That means we lost $500 on the trade.

Remember, our maximum profit in this scenario was only $328!

Theta (Time Decay) in Bull Call Ladder Spreads

The bull call ladder has a complicated relationship with the options Greek theta.

Theta, or time decay, tells us how fast the value of an option declines on a daily basis in an environment of stable stock price and volatility.

In the bull call ladder:

Theta is negative when the underlying is trading both below the lower breakeven and above the higher breakeven.
Theta is positive when the underlying is trading between these two breakeven prices.

Bull Call Ladder Spread: Choosing Strike Prices

Perhaps the most important part of trading options is choosing the right strike prices.

For a lesson on choosing strike prices on vertical spreads, check out our article here.

Once you determine the strike prices of the traditional call spread component of the ladder strategy, you must go one step further and choose the strike price of that last, very risky, out-of-the-money call option.

Here are three important reminders in your selection process:

The further an option is sold out-of-the-money, the greater that option has of expiring worthless.
Options sold closer to being in-the-money will result in a higher credit, thus a higher maximum profit potential for the ladder.
Additionally, options sold closer to being in-the-money will have a lower probability of success that out-of-the-money options.

The below image, taken from the tastyworks trading platform, shows the traditional strike price layout on an options chain for a bull call ladder spread. But remember, you can get as creative as you want with options!

Traditional Bull Call Ladder Setup

Bull Call Ladder Spread: Pros and Cons

In order to adequately understand the pros and cons of the long call ladder, we must compare this strategy to the less sophisticated bull call spread.

👍 Bull Call Ladder Pros

When compared to the traditional long call spread, the long call ladder spread expands the profit area by the credit taken in from the extra call.
The long call ladder spread also has a lower breakeven price than the long call spread on account of the extra premium taken in.

👎 Bull Call Ladder Cons

When compared to the traditional long call spread, the long call ladder spread requires much more margin. This is because the highest strike price call is sold naked.

Traditional 175/180 Bull Call BP Effect

175/180/185 Bull Call Ladder BP Effect

When compared to the traditional long call spread, the long call ladder spread requires much more margin. This is because the highest strike price call is sold naked. Opportunity costs must be taken into account when utilizing this strategy.

Bull Call Ladder Spread: Is It Worth It?

Personally, I do not believe the profit/loss profile of the bull (long) call ladder spread makes the trade worthwhile.

What we can not quantify here is the anxiety one feels when being in a position that has unlimited loss potential. This is particularly worrying when the maximum profit is capped at a relatively low level.

When you trade bull call ladder spreads, you are trading naked call option contracts. It is that simple. You can use stop loss orders on that extra short call to mitigate risk, but this by no means removes risk.

In a nutshell, the bull call ladder is an advanced options trade, and best avoided by beginners.

How strong is your stomach?

*Before trading options, traders should read the Characteristics and Risks of Standardized Options, or the Options Disclosure Document (ODD).*

Additional Resources

Quora: Bull Call Ladder Articles

The Pros and Cons of a SEP-IRA for Retirement

Posted on March 23, 2022March 30, 2022 by Mike Martin

Last updated on March 30th, 2022 , 10:17 am

The best time to start saving for retirement was years ago, but the second-best time is now. If you’re seeking ways to squirrel away money for retirement, especially investment vehicles that offer significant returns over the years, you’ve probably encountered different options.

One such option is the SEP-IRA. Is a SEP-IRA a good option? Does it have any drawbacks?

Let’s discuss.

What is a SEP-IRA?

A SEP-IRA is a retirement account designed for employers and self-employed individuals. IRA stands for Individual Retirement Account, and SEP stands for Simplified Employee Pension.

In other words, it’s a retirement account aimed at individuals and small business owners as a simple vehicle for retirement that has fewer complications than a 401(k) or a traditional pension system. It’s a traditional non-ROTH IRA, which means the money you contribute is tax-deductible, and the disbursement in retirement is taxable as income.

SEP-IRA Eligibility Requirements

The SEP-IRA is not for everyone. Due to the investment rules with a SEP-IRA, they are best for small business owners with few or no employees and the self-employed.

Why? One rule. When contributing to a SEP-IRA, you must contribute an equal percentage to the accounts of your eligible employees. If you have ten employees, that can stack up quickly; conversely, if you have zero employees or work for yourself, you don’t have to worry about it.

The equal contribution rule is based on the percentage of compensation. If you pay yourself $100,000 and pay your one employee $50,000 and want to contribute 10% of your income to your SEP-IRA, that’s $10,000 to your account. The equal percentage contribution rule requires you to contribute 10% of the employee’s compensation to their account, which is $5,000. Note that this is a simplified example, but the general rule remains.

What are the eligibility requirements? To open a SEP-IRA, you must be either an individual with freelance income or a business owner with one or more employees. Note that a business owner with zero employees still counts themselves as one employee for this eligibility.

For employees, eligibility is based on income earned from the business. Eligible employees must be 21 or older and have worked for you for 3 of the last five years. Anyone meeting those requirements, and whom you have paid over $600 in a year between 2016 and 2020, or $650 from 2021 onwards, is eligible for a SEP-IRA. And by “eligible,” we mean “required”; you must open and contribute to employee SEP-IRA accounts if you have one for yourself.

Additionally, employees control their SEP-IRA accounts. You don’t get to make decisions about how they manage or use that money; you just have to contribute to it.

SEP-IRA accounts also have much higher contribution limits than traditional IRAs. A traditional or ROTH IRA typically has a contribution limit of around $6,000 (this changes from year to year; it was $5,500 in 2018 but was increased to $6,000 in 2019 and beyond).

In contrast, a SEP-IRA has a contribution limit of $61,000 in 2022, over 10x as much. However, there is a second limitation; contribution cannot exceed 25% of compensation. If you’re paying yourself $100,000, you cannot contribute more than $25,000 to your SEP-IRA account.

What Are the Benefits of a SEP-IRA?

The SEP-IRA is a powerful investment vehicle for small businesses and individuals, with many benefits. What are they?

1. Much Higher Contribution Limits

One of the most significant benefits of a SEP-IRA is the higher contribution limits. Taking 2022 as an example, you can contribute up to $6,000 to a traditional or ROTH IRA account. However, with a SEP-IRA, you can contribute over 10x as much… assuming you make enough money to do so. The 25% of compensation limit also kicks in. Anyone making less than $24,000 per year will have a lower contribution limit than a standard IRA.

Essentially, for anyone making between $24,000 and $300,000, give or take, a SEP-IRA can save much more money, much more quickly, than with another form of IRA. The increased contribution limits can be highly beneficial, particularly if you’re in your 30s or 40s and have relatively little savings in retirement funds. In a sense, it’s a way to “catch up” on investing.

2. Easy to Set Up and Manage

In most cases, setting up a SEP-IRA is as simple as filling out some information with a brokerage and letting them handle the paperwork. You can set one up manually via the IRS, as well. It’s all quick to get the account set up and running.

Additionally, managing a SEP-IRA is simple through most firms. Usually, they’ll have a selection of pre-packaged and managed investments you can buy into, shuffle funds between, and watch grow. These portfolios are balanced according to target retirement ranges or other goals and include a variety of assets, stocks, and other investments. Since it’s all managed behind the scenes by the brokerage, you don’t have to fiddle with individual purchases or watch the markets yourself.

3. Variable Contributions

Another benefit of the SEP-IRA is that you don’t have to set a contribution rate and stick to it as you do with other forms of retirement. You can contribute a maximum of 25% of your compensation one year, but if the next year is leaner, you can choose to contribute less or even nothing at all.

The requirement to contribute the same you do for your employees can make this an ethical dilemma as a business owner, but there’s no legal requirement to contribute the maximum you can.

4. Contributions Are Tax-Deductible

Like a traditional IRA, the SEP-IRA contributions are tax-deductible as a business expense. This deduction includes your contributions and the contributions you make to your employee accounts – it can amount to a reasonably significant business expense write-off in the right situations.

Of course, if you’re self-employed or have zero employees, this isn’t meaningful compared to a traditional IRA. A small business with a small handful of employees can see quite a bit of benefit from the tax implications of those deductions.

5. Non-Exclusive with Other IRAs

There are no rules against having other kinds of IRA alongside a SEP-IRA. You can still maintain and contribute to a traditional or ROTH IRA. The only potential issues are traditional IRAs’ contribution limits and their deductions, which can get a little tricky at higher income levels.

Suppose that all of this sounds good to you – great! A SEP-IRA might be an excellent choice for your investment. However, there are a few downsides to the SEP-IRA format, which you should know before diving in.

What Are the Downsides of a SEP-IRA?

Many of the drawbacks of a SEP-IRA come down to it being a traditional IRA, though a few are specific to the SEP format.

1. All-Or-Nothing Employee Inclusion

First of all, if you’re a small business with a handful of employees and set up a SEP-IRA, you must set up accounts for eligible employees.

As a reminder, any employee who meets these requirements is eligible for inclusion in the SEP-IRA:

Employees that are over the age of 21 are eligible.
Employees that have worked for you for three of the last five years are eligible.
Employees who have been paid over $600 in a year are eligible.

You cannot pick and choose to give only management, or only vested employees, access to the SEP-IRA. Your only other option is not to use a SEP-IRA at all.

2. Matched Contributions

Whatever percentage of your compensation you contribute to your SEP-IRA, you have to contribute equally to your employee’s accounts. You might be able to swing 20% of your income into contributions, but adding in 20% of each of your employees’ salaries can be more significant. While the all-or-nothing regulation doesn’t seem devastating, it becomes harsh when adding the matched contribution percentage described above.

Of course, since the contributions are tax-deductible, this isn’t as much of a burden as you might expect it to be. Generally, higher contributions are more beneficial, save for a few rare circumstances.

3. SEP-IRAs Lack Catch-Up Limits

With a standard IRA account, you have annual contribution limits of about $6,000. However, suppose you’re over the age of 50. In that case, that limit is increased to $7,000 for older people to save more for their impending retirement, to better take advantage of interest compounding in whatever short amount of time they have before retirement rolls around.

SEP-IRAs do not have this catch-up shift in contribution limits. Your limits are the same at age 21 as at age 65. With the much higher base contribution limits, this is rarely an issue; however, it’s still noteworthy for some older investors.

4. No Added Benefit for Employees

With a standard 401(k) retirement plan, one of the benefits to the employee is that they contribute from their paycheck, and their employer matches the contribution (up to a certain point, anyway). Feeding into the account from two directions gives the employee much more money to invest and build.

With a SEP-IRA, 100% of the money contributed to the account comes from the employer. The employee cannot add more funds to the account to further invest; they will have to find other forms of retirement savings to put their own money into.

Additionally, this places the burden of funding the account on the employer. You end up with many decisions to make regarding how much you contribute.

5. Early Disbursement Penalties

Investments typically come in three forms.

Accounts you can freely add or remove money from at any time.
Accounts you can withdraw money from at any time but may pay the penalty if you’re too young (under 59 ½ years old.)
Accounts you cannot remove money from unless you demonstrate financial hardship.

SEP-IRA accounts fall into the second category. There are, generally, penalties if a younger individual tries to remove money from their SEP-IRA account. However, money may still be able to be rolled over to other IRAs. Additionally, individuals may qualify for certain exemptions from the penalty, depending on various factors specified by the IRS.

Additionally, you cannot take out a loan of your SEP-IRA funds in an emergency. A penalized withdrawal is the only option.

6. Deferred Taxes

Traditional IRAs and SEP-IRAs share the same tax implications. You can deduct contributions from your taxes when you contribute but pay taxes on the money you receive as a disbursement in retirement.

Deferred taxes can be a benefit or a drawback, depending on how you expect your income to scale. The decision between a traditional and a ROTH IRA is all about timing, tax brackets, and anticipated revenue. It can be challenging to decide, considering how few of us can plan even a few years, let alone decades.

Is a SEP-IRA Worth It?

Generally, yes, a SEP-IRA is a powerful investment tool for individual freelancers and small business owners. The larger your business grows, and the more employees you have, the less valuable a SEP-IRA plan is to you. However, should you plan to remain a sole proprietor or a freelancer, a SEP-IRA can be a great way to invest a significant amount of money in a relatively short amount of time to build up compounding interest.

Additionally, many businesses can benefit significantly from the tax deduction involved in contributing to their and their employees’ SEP-IRA accounts. Talking to a financial advisor about your specific situation is ideal, but a SEP-IRA is an excellent choice in many cases.

Often, the decision will come down to choosing between a SEP-IRA and some form of 401(k). In this case, the decision is more complex; 401(k)s have higher contribution limits as well, but dual contributions have the potential to be more valuable. Again, consider speaking with a financial advisor about your specific situation to help you make an informed decision.

Are you considering a SEP-IRA for your retirement account? Do you have any employees, and how does this affect your decision? Do you have any questions for us about opening a SEP-IRA? Please share with us in the comments section below, and I’ll do my best to point you in the right direction!

Options Trading Approval Levels: Broker Guide

Posted on March 22, 2022March 24, 2022 by Mike Martin

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

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:

Basic information on the characteristics of call and put options.
Descriptions of the risks that come with trading various options strategies.
Overview of the “exercise and assignment” process.
Tax considerations in options trading.

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

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

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

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

Can you trade options in an IRA?

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?

Can you trade options in a cash account?

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.

How do I get approved for high level options trading?

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 March 18, 2022April 1, 2022 by Mike Martin

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

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.

UVXY: ProShares Ultra VIX Short-Term Futures ETF
VIXY: ProShares VIX Short-Term Futures ETF
VIXM: ProShares VIX Mid-Term Futures ETF
VXZ: iPath Series B S&P 500® VIX Mid-Term Futures ETN
SVXY: ProShares Short VIX Short-Term Futures ETF

Warning! The ETFs and ETNs on this list are designed for short-term use. Over extended periods of time, the return of futures-based volatility ETFs deviates greatly from the benchmark!

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:

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

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

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

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

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:

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).

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:

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.

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.

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

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:

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!

Next Lesson

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

Posted on March 15, 2022April 7, 2022 by Mike Martin

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

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.

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?

An ETF issuer creates a fund that holds the underlying securities.
The fund is broken down into individual shares which smaller individual investors can buy and sell.
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.

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

Is an ETN the same as an ETF?

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.

Are ETNs safe?

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.

What are the benefits of an ETN?

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.

Is an ETC a fund?

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

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

Posted on March 11, 2022May 4, 2022 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:

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

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:

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:

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

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

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

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

Contango contributes to the massive decay in ProShare’s UVXY leveraged ETF.
UVXY uses swaps to achieve its leverage – leveraged ETFs decay faster than non-leveraged ETFs (VXX), particularly in adverse markets.
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

Is UVXY a contango?

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

What is UVXY and SVXY?

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

When can you buy UVXY?

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.

What causes UVXY to go up?

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.

Can I hold UVXY overnight?

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

Is UVXY an ETN?

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 March 10, 2022May 4, 2022 by Mike Martin

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

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

But to Open (BTO)
Buy to Close (BTC)
Sell to Open (STO)
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.

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

Buy to Open: Long Put Options

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

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

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.

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 Put Option

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

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).

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:

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.

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: 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 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:

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)

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

When should you sell to open options?

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.

What is the difference between buy to open and sell to open?

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”.

How do you buy to close a put option?

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.

When should you sell to close an option?

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 March 3, 2022April 27, 2022 by Mike Martin

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

Order Types

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

Market Order

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!

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!

Stop-loss

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.

Stop-Limit

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.

TIF Orders

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!

BTO vs BTC

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

Supplemental Video

Next Lesson

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

Posted on March 2, 2022March 21, 2022 by Mike Martin

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

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

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.

Alert! You Don't Have to Exercise! Long call and put options have the right, but not the obligation, to buy/sell stock at the strike price. If the owner of a long option does not wish to exercise their right at expiration, they must communicate this to their broker. Otherwise, long in-the-money options are automatically exercised.

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.

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

Can I still sell options on expiration day?

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.

Can I exercise options on the expiration date?

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.

Are in the money options automatically exercised at expiration?

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.

What happens when calls expire ITM?

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

What are Cash Secured (Covered) Puts?

Cash Secured Put Risks

Cash Secured Put Trade Example

Cash-Secured Put: Outcome #1

Assignment/Exercise Process

Cash-Secured Put: Outcome #2

How Much Money Do You Need for a Cash Secured Put?

➥AMZN: Short 2700 Put for $2

➥NOK: Short 4 put for $0.25

Is a Covered Put the Same as a Cash Secured Put?

Covered Put Chart

Are Cash Secured Puts a Good Strategy?

Cash-Secured Put + Covered Call Strategy = The Wheel

Can I Sell Put Options in My IRA?

Cash Secured Put vs Short Put

Cash-Covered Put: Margin Account

Cash-Covered Put: IRA Account

Cash Secured Puts FAQs

Next Lesson

Shorting Put Options for Income Explained

Short Put Option Payoff Results from 41,600 Trades [Study]

Long Call vs Short Put: Comparing Strategies W/ Visuals

Bull Call Ladder Profile

Bull Call Ladder vs Bull Call Spread

Long Call Ladder Visualized

Long Call Ladder Trade Example

Winning AAPL Long Call Ladder at Expiration

Losing AAPL Long Call Ladder at Expiration

Theta (Time Decay) in Bull Call Ladder Spreads

Bull Call Ladder Spread: Choosing Strike Prices

Traditional Bull Call Ladder Setup

Bull Call Ladder Spread: Pros and Cons

👍 Bull Call Ladder Pros

👎 Bull Call Ladder Cons

Bull Call Ladder Spread: Is It Worth It?

Next Article

The ﻿﻿Ultimate﻿﻿ ﻿﻿﻿Bullish﻿﻿﻿ Option Strategy Guides

Bearish Options Trading Strategies (In-Depth Tutorials)

Neutral Options Trading Strategies (In-Depth Tutorials)

Additional Resources

What is a SEP-IRA?

SEP-IRA Eligibility Requirements

What Are the Benefits of a SEP-IRA?

1. Much Higher Contribution Limits

2. Easy to Set Up and Manage

3. Variable Contributions

4. Contributions Are Tax-Deductible

5. Non-Exclusive with Other IRAs

What Are the Downsides of a SEP-IRA?

1. All-Or-Nothing Employee Inclusion

2. Matched Contributions

3. SEP-IRAs Lack Catch-Up Limits

4. No Added Benefit for Employees

5. Early Disbursement Penalties

6. Deferred Taxes

Is a SEP-IRA Worth It?

Next Article

Target-Date Funds vs S&P 500 Index Funds: Which is Better?

What’s the Best Stock to Bond Ratio for Your Age?

How Do You Get Options Approval?

What is Required to Get Options Trading Approval?

General Option Trading Levels

Option Trading Approval Levels by Broker

Tastyworks Option Approval Levels

tastyworks

Fidelity Option Approval Levels

Fidelity

E*TRADE Option Approval Levels

E*TRADE

Robinhood Option Approval Levels

Robinhood

TD Ameritrade (thinkorswim) Option Approval Levels

Ameritrade

Option Approval FAQs

Next Lesson

Options Trading for Beginners

Buy to Open vs Buy to Close

Option Order Types Explained

UVXY vs VIXY vs VIXM vs VXZ vs SVXY

How does the UVXY ETF work?

The Ultimate Bullish Option Strategy Guides