Mike Martin

5 Major Risks of Options Trading

Posted on December 20, 2021February 11, 2022 by Mike Martin

Last updated on February 11th, 2022 , 07:23 am

When you’re trading stocks, your only true risk is directional. If you’re long a stock, your risk is that this equity will down in value. If you’re short a stock, your risk is this equity goes up in value. As long as the markets are “liquid”, these are the only true risks in stock trading.

Options trading, on the other hand, introduces traders to a myriad of risks.

In order to understand the risks of derivatives, we must first understand what, exactly, options are. If you already know these basics, please skip ahead directly to the 5 risks of options trading.

TAKEAWAYS

Call options are leveraged bullish market bets; put options are leveraged bearish bets.
Options are decaying assets. An options time decay, or “theta”, refers to the rate at which an option price declines as time passes in a constant environment.
Implied volatility risk occurs after major events, such as earnings and economic data.
Dividend risk applies to short call positions and occurs in the days leading up to the “ex-dividend” date.
Pin risk occurs when the price of a stock/ETF is trading very close to the strike price of an option in the moments leading into expiration.
Memory risk is perhaps the most important on our list. Options traders must remain diligent.

Options Trading Explained

An option is a financial instrument that allows an investor to place leveraged bets on an underlying security. This exposure can either be on the upside or downside. Options can also be used as vehicles to hedge, but this article is going to focus on options as financial instruments of speculation, as this is how most investors employ them.

One option contract almost always represents 100 shares of stock. This great leverage introduces great risks.

There are only two types of options; call options and put options. Call Options are “bullish” bets while “put options” are bearish bets. Let’s next examine each one of these contracts closer.

Call Options Explained

Call Option Definition: A call option is a contract that gives an owner the right, but not the obligation, to purchase 100 shares of a stock at a specified strike price on or before an expiration date.

Call options are bullish. If you believe a security will go up substantially in value, a call option can offer you:

Let’s say AAPL is trading at $170 per share. You think, that by next month, the price of AAPL will surpass $180 dollars. Let’s take a look at the details of an options trade that would profit should AAPL exceed $180 in one month.

Here are the details of our trade:

AAPL Stock Price: $170

Call Strike Price: 180

Call Price: $3 ($300)

Expiration Date: January 17th (30 days away)

So we paid $3 for this call option. You will recall earlier we mentioned that one option contract represents 100 shares of stock. Though the quoted price of this option is $3, we actually paid $300 for it.

Let’s fast forward 30 days now to expiration and see how our trade did!

Call Outcome #1: Maximum Loss

So let’s say a month has passed. We were wrong. AAPL is trading at only $179. Of course, it went up in value; but not enough for us. In this scenario, since the stock price did not reach our strike price by the expiration date, our call will expire worthless.

This 180 strike price call gave us the right to purchase AAPL stock at $180 per share by our expiration date. Since the stock is trading below this price, why in the world would we exercise our right to purchase the stock at a higher price? We wouldn’t. Therefore, our trade results in a maximum loss of $300.

Call Outcome #2: Profit

In this scenario, let’s say AAPL rallied all the way to $185 in value on expiration day. How did we do?

A lot better! Our 180 strike price option is “in-the-money” by $5 here. So did we make the difference of $500? Not quite. Remember, we paid $3 for the option to begin with. Therefore, this $3 must be subtracted from our $500 profit. To determine our net profit, we simply subtract this premium paid of $3 from the amount the option is in-the-money by ($5), giving us a net profit of $2. Taking into account the multiplier effect, this $2 would represent $200 in profits.

Could we have made more than this? Sure! Since there is no cap on how high a stock can go, a long call has infinite profit potential.

Put Options Explained

Put Option Definition: A put option is a contract that gives the owner the right, but not the obligation, to sell 100 shares of a stock at a specified strike price on or before an expiration date.

Everything we learned of call options is true of put options, with one major difference: put options bet on a downward move in the stock.

Let’s take a look at that same trade, but this time we think AAPL will be trading not at $180 in one month, but $160, making us bearish. We will therefore buy a put option.

Here are our trade details:

AAPL Stock Price: $170

Put Strike Price: 160

Put Price: $3 ($300)

Expiration Date: January 17th (30 days away)

Put Outcome #1: Maximum Loss

So let’s say the 30 days have passed and our put option is expiring. AAPL is trading at $165 on this date. Our put option gives us the right to sell 100 shares of AAPL at $160 per share.

When you sell a stock, you want to sell it for as much value as you can. Therefore, why would you sell stock at $160 per share when the current market value is $165?

You wouldn’t. Therefore, this 160 strike price put option will expire worthless, and we will lose the entire $3 ($300) premium we paid for it.

Put Outcome #2: Profit

In this scenario, let’s say AAPL fell all the way to $152 on expiration day. Our 160 strike price put is therefore in the money by $8 ($800).

But did we make $800? Not quite. Remember, we need to subtract the debit paid from this amount. We paid $3 ($300) for this option, therefore we will see a net profit on this trade of $500 ($800-$300).

In a nutshell, these are the basics of options contracts. If you’d like a complete lesson, please check out our video, Options Trading for Beginners below. 12 million views and counting!

Let’s now take a look at some key risks in options trading. Bear in mind that these are only a few of the more salient risks: options trading has dozens of them!

1.) Time Decay Risk

Options, unlike stocks, have a lifespan. They are decaying assets. If you buy a 180 call on a stock that is trading at $175, and in a week from now the stock price hasn’t changed, your call option will most likely go down in value. This is assuming implied volatility hasn’t changed.

Why will it go down? Because as time passes, the odds that that stock has of reaching your strike price have diminished. This is known as “time decay”.

Professional options traders rely on a set of risk management metrics called “The Greeks” to mitigate risk. There is indeed a Greek pertaining to time decay, and it is called “theta”.

Theta tells us how much an options contract will go down over the course of a day should all else (stock price and implied volatility) remain the same. The below table shows us how this Greek interacts with a long call position.

Type	Strike	Price	Theta
Call	147	3.25	-.52
Call	148	2.63	-.56
Call	149	2.11	-.54

For each day that passes, in an environment where all else remains constant, the theta values above tell us how much each corresponding option will decline in value.

So time decay is indeed a risk to option buyers; but what about option sellers? If you buy an option, somebody has to sell you that option, right? Traders’ short options love time decay, because, unlike option buyers, they want that option to go down in value.

2.) Volatility Risk

An option’s value is comprised completely of extrinsic and/or extrinsic value.

Intrinsic Value Definition: In options trading, the intrinsic value represents the value of an option should that option be exercised at the moment of observation.

Extrinsic Value Definition: In options trading, the extrinsic value represents all option value that is not intrinsic value.

So what, exactly, comprises extrinsic value?

Time Decay
Implied Volatility

We just learned above about time decay. Let’s now explore the other half of extrinsic value – implied volatility. This metric also happens to be our next options trading risk.

All options have assigned implied volatility. This figure tells us the expected move of an underlying security over a certain time frame.

In addition to different stocks having different implied volatility levels (IV), the different expiration cycles within each stocks options chain have their own unique IV levels, as illustrated on the tastyworks trading platform below.

Implied Volatility per Expiration

If a company is to release earnings in the days ahead, this will probably cause the stock to either go up or down more in value than on a normal trading day. Because of this, events like earnings (or even economic news) can jack up IV levels.

Guess what happens after the news is released? Bingo. The IV levels (usually) drop. This is referred to as “volatility crush” and is a great risk to long options traders. When the IV of a specific options expiration goes down, so does the premium of all options listed under this expiration.

Just like with time decay, this is a negative for long option positions but a positive for short options.

3.) Dividend Risk

Dividend risk applies to all short call option positions on a dividend issuing security.

Owning stock comes rights. One of these is the right to share in corporate profits via dividends. Options, however, have no such rights. Therefore, sometimes, it makes sense for a long call to exercise their right to purchase stock before a dividend is issued to collect this dividend. This poses a risk for short-call positions.

In the time leading up to the “ex-dividend” date, assignment risk on short in-the-money calls can rise.

If the value of the issuing dividend exceeds the value of a short call option, dividend risk is indeed present.

4.) Pin Risk

Pin Risk Definition: Pin risk arises when the price of a security is trading very close to the strike price of an options contract at the moments leading up to expiration.

A lot can happen in the moments leading up to an options expiration.

Let’s say we are short the AAPL 170 call while AAPL is trading at 169.50. It is the day of expiration and there are only 2 minutes left in the trading day.

At the moment, we are safe. As long as AAPL stays under 170, we will remain safe. But what if, in the last two seconds of trading, a wave of buy orders comes in, sending AAPL to $170.15?

Our option is in-the-money, and the markets are closed. So what can we do? Not much. We will probably be assigned on our short call, and forced to sell 100 shares of stock. We could hedge this risk by buying 100 shares, but there is no guarantee that we will be assigned. This is a messy situation and can result in huge monetary losses.

To eliminate pin risk, close out of any short at-the-money options before the bell rings. It’s that simple.

This risk can be present in long options too, but long options can inform their broker to NOT exercise their contract. This is assuming the trader is paying attention. This brings us to our next risk.

5.) Memory Risk

After working in the retail options industry for 15 years, I can tell you the greatest of all risks comes from individual traders’ negligence.

Options trading requires diligence. There are a lot of moving parts in this business. You have to stay on top of your game at all times. The “set it and forget it” mentality does not work in options trading.

If you tend to be forgetful, make it a habit to set reminders for important upcoming events, such as “earnings calls” and important expiration dates. If you are habitually forgetful, options trading probably isn’t for you. There are simply too many risks!

Final Word

This list is by no means exhaustive. For example, “liquidity risk”, just like in stocks, is present in options. You want to make sure there is sufficient volume in a stock before placing an options trade on that stock. Additionally, the bid-ask spread should be tight.

Hopefully the above list will get you started on understanding the risks of options trading.

A lot of money can be both made and lost in options trading. It is always best to start small and slowly increase your positions as you become more comfortable.

All new traders eventually make a mistake. However, it is far better for this mistake to involve a one-lot than a one-hundred lot!

Next Lesson

Additional Resources

Is it Risky to Invest in Options? – Investopedia

Options: What are the Benefits & Risks? – Options Industry Council

How Options Provide Leverage (And the Risks Involved)

Index Options Trading Explained (Guide w/ Visuals)

Posted on December 16, 2021February 11, 2022 by Mike Martin

Last updated on February 11th, 2022 , 07:34 am

	INDEX OPTIONS	ETF OPTIONS	EQUITY OPTIONS
Exercise Style:	European	American	American
Settlement:	Cash-Settled	Physical Delivery	Physical Delivery
Tax Advantages:	Has Tax Advantages (60/40)	No Tax Advantages	No Tax Advantages
Dividends:	No Dividends	Dividends	Dividends

An index option is a derivative financial instrument that gives the buyer the right, but not the obligation, to either buy (call) or sell (put) an underlying index at a specific strike price on an expiration date.

In the world of options trading, there are three dominating categories of underlying’s upon which derivatives are based:

Equity Option Definition: These types of contracts use a specific stock as their underlying, such as Apple (AAPL) or Tesla (TSLA).
ETF Option Definition: These types of options use exchange-traded funds (ETFs) such as SPY and QQQ as their underlying. The values of ETF options are derived from the physical stock which composes whatever basket of funds that ETF tracks.
Index Option Definition: Index options track “indices” which, unlike ETFs, are not actually comprised of individual stocks, but a non-equity issuing benchmark index, like SPX or NDX.

To differentiate index options from the others on our list, let’s start by looking how these types of options are exercised.

TAKEAWAYS

Index options track a non-share issuing underlying index
These types of contracts are settled in cash, reducing the large monetary risk that comes with other types of options that are physically settled
Index options are “European” style. These types of options can only be exercised at expiration and therefore pose no early-assignment risk to short positions
Because of the “60/40” rule, index options benefit from reduced taxation
Indices pay no dividends, therefore dividend risk is eliminated in index options.

Index Options: European Style

All options contracts are either settled in the “American” or “European” style.

American Style options allow the owners the right to exercise their call or put option any time before and including the expiration date.

European Style options can only be exercised on the day of their expiration.

All index options are settled in the European style.

This is great news for traders’ short options. Early assignment risk is virtually removed from index options.

If you are short a call or short a put option on a stock (like AAPL) or ETF (like QQQ), your long counter-party has the right to exercise this option at any time.

Early exercisement can occur when an options extrinsic value plummets, or when dividends are issued (for calls). Additionally, short options can in theory be assigned at any time. This may not be a bad thing, but it can still be a risk nonetheless.

With index options, this early-assignment risk is virtually removed. This is one reason professional traders prefer trading options on indices, like SPX (CBOE) and NDX (NASDAQ).

Index Options: Cash-Settled

Image from CBOE.com

All options contracts are setted either via cash or physical deliver.

Physical Delivery settled options require actual delivery of the underlying product (whether it be stock or ETF)

Cash- Settled options simply require an exchange of cash equal to the options notional value at the time of expiration

Index options are cash-settled.

When an option is exercised (and thus assigned) the short party must produce a lot of capital to hold that position. For equity and ETF options, 100 shares of stock are exchanged per one lot.

For retails who don’t always watch their accounts closely, this can be huge risk. If you were short a call option on AMZN going into expiration and forgot to buy it back, you would be required to have (at its present value of $3,400) $340,000 in your account! This can result in huge monetary losses.

This is just yet another reason why index options are typically the favorite of professional traders.

Index Options: Tax Advantages (60/40)

Image from CBOE.COM

When compared to equity and ETF options, index options offer investors a pretty substantial tax break. Let’s take a look first at how equity and ETF trades are taxed, then look at the advantages that index options have over them.

Normal Taxation

For investors trading in taxable accounts, both long-term and short-term capital gains must be paid (depending on the position duration). These taxes are often contingent upon an investor’s net income.

Short-Term Capital Gains apply to the profits made on positions held for under one year.

Long-Term Capital gains apply to profits on positions held for more than one year and are taxed at rates varying from 0% to 20%.

Almost in every situation, paying long-term capital gains is preferred to short-term capital gains. Why? Short-term capital gains are taxed at your normal tax rate. Long-term capital gains are taxed at (lower) rates varying between 0% to 20%.

Index Option Taxation

Index options are taxed a little differently than this. According to section 1256 from IRS.gov, gains on index options are treated at 60% long-term capital gains and 40% short-term.

Short-term capital gains are almost always higher than long-term capital gains. Sometimes, traders hold positions for over one year just to avoid paying short-term capital gains.

Section 1256 tells us that no matter how long you hold an index option (be it a minute or year), the profits on these transactions will be taxed at the 60/40 rate. This is quite the monetary benefit indeed!

This is the third way in which index options are superior to equity and ETF options.

Index Options Eliminate Tracking Error

The above graph (compliments of the Financial Times) shows how the values of ETFs can deviate from that of the underlying benchmark that they represent.

This generally isn’t a problem for more liquid ETFs (such as SPY and QQQ), but when you’re trading more exotic ETFs, the performance of the product can sometimes differ from the securities it attempts to represent. ETFs employ fund managers and price stabilizers to keep this price in line, but it doesn’t always work.

Index options track an index without having to worry about acquiring the individual stocks that comprise that index. Therefore, with index options, you know its current market price will (almost) always be 100% in line with its true value.

Index Options Pay No Dividends

The majority of ETFs and stocks pay dividends.

This poses a risk to those short options, particularly calls. Since options do not pay dividends, sometimes it makes sense for a party long a call option to exercise their contract. This mostly occurs on options that are deep in-the-money.

If you are short that option, this will most likely result in a monetary loss to your account. I remember working for an advisor who neglected to trade out of an “ex-dividend” short call position. I also heard about the trader on the floor who decided to “exercise” this long call – it was a lot of risk-free money to him!

Popular Index Options List

SPX – S&P 500 Index
NDX – NASDAQ 100 Index
RUT – Russell 2000 Index
DJX – Dow Jones Industrial Average 1/100 Index

OEX – S&P 100 index
VIX – S&P 500 Volatility Index
XEO – S&P 100 (European) Index

Final Word

In summation, we can conclude that index options do indeed offer traders many advantages over other types of options.

Index options eliminate early assignment risk.
These options do not require physical delivery (a risk to neglected short option positions).
Index options offer superior tax advantages.
With index options, dividend risk is removed.

So it seems like index options are all upside. Are there any drawbacks?

Perhaps one of the few disadvantages of index options lays in their strike prices.

Index options generally have strike prices listed 5 points apart. For smaller retail accounts looking to do small trades (like a one-point vertical spread) this would be an impossibility.

ETFs on liquid products like SPY, on the other hand, offer even half-point strike prices.

Next Lesson

Additional Resources

Index Option Definition – Investopedia

What is index option trading? : Investopedia

The Differences Between Index Options and Stock Options : Nasdaq.com

Implied Volatility Explained (The ULTIMATE Guide)

Posted on December 14, 2021May 2, 2022 by Mike Martin

Last updated on May 2nd, 2022 , 07:40 am

Implied Volatility Definition: In the financial markets, Implied Volatility (IV) represents the expected volatility of a stock, ETF, or index over the life of an option. IV helps to determine the prices of options.

There are few trading terms more daunting to the beginner options trader than implied volatility.

However, when broken down into its parts and looked at visually, this concept can be mastered by anyone willing to take the time to learn.

If you want to become a serious options trader, you must understand implied volatility. It’s that simple.

Let’s get started!

TAKEAWAYS

Implied volatility uses options to forecast the likely future movement of a security’s price
IV can help predict future price movements caused by upcoming earnings, economic data and interest rates.
Historical volatility measures past moves in a stock’s price over a predetermined time frame
1 Standard Deviation includes 68% of outcomes; 2 Standard Deviations includes 95% of outcomes
IV (Implied Volatility) Rank tells traders whether implied volatility is high or low based on IV data from the past year
IV (Implied Volatility) Percentile is frequency-based. This measure shows traders how often a stocks implied volatility has been below the current level of implied volatility over the past year.

What is Implied Volatility?

Aside from being vehicles of hedging and market speculation, options (derivatives) also help traders to predict future stock movements.

They do this by incorporating components of the Black-Scholes option pricing model formula relating to the price variation of options contracts.

To better understand how options are able to do this, let’s jump right into an example by comparing the option premiums on two different stocks with similar prices.

PEP Option: 37 Days to Expire

Stock: $102

105 Strike Call Option Price: $0.80

100 Put Price: $1.17

Implied Volatility: 16.4%

UNP Option: 37 Days to Expire

Stock: $103.60

105 Strike Call Option Price: $2.72

100 Put Price: $1.92

Implied Volatility: 30.9%

Let’s first note the different prices of these stocks. PEP is trading at $102; UNP is trading at $103.60. These prices are quite similar. However, we can see that the options on UNP are trading substantially higher than the selfsame options on UNP. Why are the options premiums on UNP so much higher? Because the implied volatility on UNP is higher!

The high premiums on UNP, therefore, suggest that the underlying stock is expected to move further (either up or down) than the stock of PEP.

Implied Volatility and Extrinsic Value

An option’s premium consists of extrinsic and/or intrinsic value. When we’re talking implied volatility, we are focusing only on the extrinsic value of an options price.

Implied volatility represents the amount of extrinsic value that exists in a stock’s options relative to the time until the expiration date.

Option Buying/Selling and Implied Volatility

When options buyers pay a high amount of premium for call and put options, the sellers of those options must therefore receive substantial credits.

Therefore, high volatility is implied by the option prices.

When option buyers pay relatively small amounts of premium for long call and long put options, option sellers receive small credits as well. This means that neither party is expecting the underlying asset price to move by much.

Here, low volatility is implied by the option prices.

So, what makes traders pay high premiums for some options? It’s not completely arbitrary – there is a method in the madness of options pricing.

The answer to this lay in “historical volatility”. Let’s compare this term to implied volatility next.

Implied Volatility vs Historical Volatility

Historical Volatility Definition: A statistical indicator that measures the historical return distribution for a security over a predetermined period of time.

The above image compares the one-month historical volatility of the S&P 500 against the VIX index after recording the levels of observed volatility.

The VIX measures one-month option prices on the S&P 500 index. By comparing the S&P 500 historical volatility to the VIX index, we can draw a conclusion as to whether or not historical volatility has any impact on the S&P 500 options prices.

We can draw three conclusions from the above comparison:

S&P 500 option prices (as measured by the VIX Index) are closely related to the amount of historical volatility in the S&P 500.
At low levels of historical volatility, the VIX Index (one-month SPX option prices) tends to be low.
At higher levels of historical volatility, the VIX Index (one-month SPX option prices) tends to also be high.

To conclude, historical volatility looks at past volatility while implied volatility looks at future volatility.

Implied Volatility and Probability

When you look at an options chain, you will see that every option expiration cycle has an implied volatility (IV) level associated with it.

So what does the implied volatility of an option actually represent? Let’s break this number down.

Implied Volatility is Annualized

Implied volatility is expressed as an annual percentage (Optiver). Even if the options on your chain expire in 30 days, the IV number is still annualized.

The IV percentage in our above options chain represents the “one standard deviation” stock price movement over a one-year period.

In statistics, a one standard deviation range encompasses about 68% of the outcomes around the mean/average.

Expected Range Formula

In the stock market, this mean/average is the current price of a stock. Here is the formula to compute this:

1 – Year Expected Range = Stock Price +/- (Stock Price x Implied Volatility)

Let’s take a look at a few examples now to really understand this.

Expected Range Example

Below you will find our trade details.

NFLX Trade Details

Stock: $374

IV: 39%

1 SD Range (1 Year): $228.14 – $519.86

The above information tells us there is a 68% probability (1 SD) that NFLX is within +/- 39% of its current price of $374 in one year.

Let’s take a look at one more example.

KO Trade Details

Stock: $52

IV: 20%

1 SD Range (1 Year): $41.60 to $62.40

In this trade, there is an estimated 68% chance that KO is within +/- 20% of its current price of $52 in one year. Pretty simple, right?

Let’s next take some time to visualize SD and implied volatility.

1 Standard Deviation Explained

The above chart shows a $100 stock with 25% implied volatility. 68% of the area under the curve falls between $75 and $125, indicating that the market is implying a 68% probability that the stock price is between these two levels one year from today.

This doesn’t mean that the stock price won’t trade beyond this price, but it does imply the odds of this happening are relatively low.

So this chart shows a 1 standard deviation move; what about 2 and even 3 standard deviation moves – what will they look like?

2 Standard Deviation Explained

The above image shows a $100 stock at 25% implied volatility. Simply multiplying the 1SD range by 2 gives us the 2SD range, which is the implied 95% probability range.

1SD Range (68%) = +/- $25
2SD Range (95%) = +/- $75

So all this tells us is that our stock has a 95% chance of remaining between $50 and $150 one year in the future.

Every stock has its own level of volatility. Some stocks are high volatility; others are low. Let’s next compare these two.

Low IV vs High IV

The above chart compares two similarly priced stocks; one with a 10% IV (green) and another with a 25% IV (blue).

We can see that the 10% IV stock (which has cheaper option prices) is not expected to deviate too far from its current price of $100.

On the other hand, the 25% IV stock (which has very expensive options) is implying large stock price fluctuations in the future price (relative to the 10% IV).

Again, this information is all relayed to us via the options market. In an environment where the stock price is the same, the stock with a higher IV is expecting to move more (in either direction) and therefore has higher-priced options.

IV Rank and IV Percentile

These two implied volatility metrics help traders to determine whether a stock’s IV is currently high or low relative to the stock’s historical levels of IV.

By only looking at a stock’s current IV, it is not immediately clear whether that level of IV is low or high.

In order to determine whether a stock’s IV is fairly priced, traders look to IV Rank or IV Percentile.

Both of these metrics measure a stock’s current IV against its historical levels of implied volatility. Let’s look at these closer next.

Implied Volatility Rank

IV Rank is a calculation that takes a stocks current level of IV and compares this with the highest IV as well as the lowest IV that has been observed in that stock over the past year.

Here is the formula for this:

A 20% IV stock with a one-year IV range between 15% and 35% plugged into this formula would appear as below:

Different IV ranks can tell us many things.

An IV rank of 0% indicates the current implied volatility is the lowest its been over the past year
An IV rank of 50% indicates the current implied volatility is at the midpoint of the IV range seen over the past year
An IV rank of 100% indicates the current implied volatility is the highest its been over the past year

Implied Volatility Percentile

Unlike IV Rank, IV percentile is frequency-based. IV percentile shows us how often a stocks implied volatility has been below the current level of implied volatility over the past year.

For example, an IV Percentile of 85% means the stock’s IV has been below its current IV level on 85% of days over the past year.

Here is the formula used to reach this figure:

We are dividing by 252 and not 365 because there are only 252 trading days in a year.

For example, if a stock’s IV has been below the current IV on 180 of the past 252 trading days, the IV percentile would be:

This IV percentile of 71.42% means the stock’s IV has been below its current IV on 71.42% of trading days over the past year.

IV Rank vs IV Percentile: Which is Better?

Every trader has their own preference here. However, one of the limitations of IV rank is that it does not tell you the frequency at which a stocks implied volatility was lower than the current level of implied volatility.

Instead, IV Rank simply tells us where a stock’s current level of IV falls within the one year IV range.

A downside of IV Rank is that after a period of abnormally high IV, the IV Rank will come in at lower readings for almost all levels of IV into the future, regardless of whether or not that level of IV is still high or low.

To prove this, lets compare S&P 500 implied volatility to IV Rank.

S&P 500 IV vs IV Rank

If you focus on the left side of the chart, you’ll see the S&P 500 IV was around 22.5%, which translated to an IV Rank of over 75%.

However, later on in the year, IV spiked to 40%. In the shaded region on the right of the graph, you’ll notice that the IV rose to 25% but the IV Rank was less than 50%.

When IV falls after a surge in IV, IV Rank readings will be low even when the IV of a stock is still relatively high.

In this example, the IV of the S&P 500 is below 20% most of the year, but after the spike in IV, the subsequent IV of 25% translated to an IV Rank of less than 50% later in the year.

Let’s look at how IV Percentile tracks the S&P 500 IV next.

S&P 500 IV vs IV Percentile

The above chart compares the S&P 500 implied volatility to IV Percentile.

Since IV Percentile is frequency based, this metric falls more in line with the S&P 500 implied volatility. Therefore, this measure gives us a better representation of true market volatility over periods of time.

Final Word

This material should get you started on your journey to learning about implied volatility. If you’d like to learn more, please check out Chris Butler’s video on the subject, which builds upon the topics in this article as well as expands into the world of implied volatility and company earnings.

Implied Volatility FAQs

Is a higher implied volatility good?

Higher levels of IV (implied volatility) result in higher option premiums. Therefore, if you are selling options, a higher IV means a higher reward. Of course, higher reward potential comes with greater risk.

Do I want implied volatility to be high or low?

Determining the ideal level of IV will depend on your options trading strategy. Generally, option sellers prefer a high IV when entering trades, and a lower IV over the course of the options life.

What is the difference between volatility and implied volatility?

Volatility, also known as historical volatility, represents the past volatility of a stock, ETF, or index. Implied volatility represents the future potential volatility of a security, as measured by that securities option prices.

Next Lesson

Additional Resources

Implied Volatility (IV) Definition – Investopedia

Implied volatility – Wikipedia

Implied Volatility for Trading Options | tastytrade

What is The Straddle Options Strategy? Simplified w/ Visuals

Posted on December 9, 2021April 5, 2022 by Mike Martin

Last updated on April 5th, 2022 , 06:29 am

The straddle is a vital trading strategy that all options traders must have in their toolbox. Even if you never place a straddle, the information this strategy relays to us is of utmost importance.

In this article, projectfinance will be reviewing both the long and short straddle options strategy. We will also examine how this strategy, regardless of whether or not you actually trade it, can give us a pretty good idea as to the future movement of a stock, ETF, index, or any security, for that matter.

Let’s start by looking at the long straddle.

TAKEAWAYS

A straddle consists of both a call and put option on the same security, strike price, and expiration date.
In a long straddle, both the call and put options are purchased
In a short straddle, both the call and put options are sold
Long straddles benefit from either large upside or downside movements in a stock
Short straddles benefit in flat, or sideways markets
At-the-money straddles on near-term options help traders to forecast a stock’s expected move

Long Straddle Explained

Long Straddle Definition: In options trading, a “Long Straddle” position is established when both a call and a put contract are purchased on the same strike price and expiration date for a security.

In options trading, you can both buy and sell all strategies. When your trade results in a net debit (meaning it costs you money) the cost of this trade will be debited from your account.

Long Straddle Components

Long Put X
Long Call Y

So all we are doing here is buying both a long call and long put option simultaneously. In order for our net position to result in a straddle, our options must be:

On the same security
Of the same strike price
Of the same expiration date

When all of these conditions are met, you will have a long straddle.

Since we are a net purchaser of options here, we expect the underlying stock to move. But in what direction? That’s the beauty of a straddle: since we are long both a call and put, if the stock moves up OR down, by a lot, we will make money.

But under what conditions will we make money? How far does the stock have to move? Where do we break even?

Let’s first take a look at at the profit/loss profile of this trade, then an example.

Long Straddle Profile

Long Straddle Maximum Profit:

Unlimited, no cap on the call

Long Straddle Maximum Loss:

Total debit paid

Long Straddle Break Even:

Upside: Long call strike Y (plus) total premium paid

Downside: Long put strike X (minus) total premium received

Long Straddle Example Trade

To begin, we must first choose the strike price of the call and put that we will be buying. For straddles, this strike price is almost always close to or at-the-money.

Take a look at the below sample options chain.

We said before that most long straddles use at-the-money options. Since the stock is trading at $250 here, we have purchased both the at-the-money 250 call and 250 put for a net debit of $30.30.

Buying at-the-money options allows us to profit from equal upside and downside stock moves. If you purchased that straddle at the $275 strike price, you would be much more bullish and the profile/loss profile would be skewed.

Let’s take a look at a visual of this at-the-money straddle, then break down its profit/loss profile.

Long Straddle Chart

Long Straddle Maximum Profit

In theory, the maximum profit is unlimited on straddles. This is because of the long call. Since there is no cap on how high a stock can go, the value of a call can theoretically go to infinity.

Long Straddle Maximum Loss

Whenever you purchase options, the most you can ever lose is the premium paid. Since we paid $30.30 for this straddle, our maximum loss would be $3,030 (taking into account the options multiplier effect of 100).

When would this happen? If the stock closes at $250 exactly on the expiration day. Under this scenario, both our long call and long put would be (just about) worthless.

Long Straddle Break Even

Since we are long two options, we have two breakevens.

Call Break Even: 250 + 30.30 = $280.30
Put Break Even: 250 – 30.30 + $219.70

In order to determine the break even here, we must start by looking at our total debit paid. On expiration day, one of these options must have enough value to gain us $30.30, our net debit paid.

That’s a pretty big move! And if that happens, we will only break even. In order to make money, the stock price needs to move more than $30.30 in either direction.

Therefore, you should only purchase a straddle when you believe the underlying price will move by a substantial amount. If you were confident in the future direction of a stock’s movement, you wouldn’t buy a straddle, but simply a call or put.

Let’s now take a look at the short straddle, which is simply the exact opposite of what we just learned.

Short Straddle Explained

Short Straddle Definition: In options trading, a “Short Straddle” position is established when both a call and a put contract are sold on the same strike price and expiration date for a security.

Since we are net sellers of options here, we will be receiving a credit for this trade. Therefore, this trade will result in a credit of cash to our account.

We learned before that the long straddle profits when the stock moves a lot. Short straddles are the exact opposite; these strategies profit when the underlying stock moves very little.

Therefore, this strategy is best for more market-neutral traders.

Short Straddle Components

Short Put X
Short Call Y

Just as with the long straddle, the short straddles must be composed of options that are:

On the same security
Of the same strike price
Of the same expiration date

Let’s take a look at this strategy’s profit/loss profile, then move on to an example.

Short Straddle Profile

Short Straddle Maximum Profit:

Total credit received

Short Straddle Maximum Loss:

Unlimited, there is no cap on how high the short call can go

Short Straddle Break Even:

Downside: Short put strike X (minus) total premium received

Upside: Short call strike Y (plus) total premium received

Short Straddle Example Trade

Just as with the long version of this trade, we are going to placing the short version with at-the-money options (the 250 strike price from the below options chain).

So we have sold both an at-the-money call and put option here. Under what circumstances would a trader place this trade? When they believe the underlying is not going to move.

Generally, straddles are sold when a trader believes the options premium (due to implied volatility) is too high. The volatility of options (particularly short-term options) is usually elevated before major market events, such as earnings reports and unemployment numbers.

Next, let’s take a look at a visual of this trade, as well as the circumstances under which we will make money, lose money, and break even.

Short Straddle Chart

Short Straddle Maximum Profit

Whenever you are a net seller of options, your maximum profit is always the credit that you take in.

For this trade, we took in a credit of $30.30. Therefore, when accounting for the multiplier effect, our maximum profit is $3,030.

Short Straddle Maximum Loss

When we went over the long straddle, we said that (because of the call) maximum profit was unlimited. Guess what the maximum loss is for the short straddle? Bingo. Unlimited. That short call can, in theory, go to infinity.

It is because of this great risk that brokers usually require a substantial margin to hold these trades.

Short Straddle Break Even

Again, since we have two options, we have to break evens:

Call Break Even: 250 + 30.30 = $280.30
Put Break Even: 250 – 30.30 + $219.70

Our net credit for this trade was $30.30. Therefore, either of our short options must be trading at this value on expiration for us to break even. This occurs in either of the above two listed scenarios.

Short Straddle: The Expected Move

The straddle (whether actually traded or not) is an invaluable asset to traders. Why? It can do a pretty darn good job of predicting future stock price movements.

Let’s take a look at a TSLA options chain on the tastyworks trading platform.

TSLA Options Expiring in One Day: Stock at $2,965

The above options expire in one day. Let’s assume that Tesla will release earnings tomorrow morning. The stock is currently trading at $2,965.

By adding together the combined premiums of both the at-the-money 2965 calls and 2965 puts, we can get a ball park range of how much TSLA will move post earnings.

In this instance, the stock is expected to move by about $30 ($15 + $15).

Using straddles to predict future price movement is a great window into the (potential) future of a stock. If you’d like to learn more about the expected move, check out this article by MarketWatch, which tells of calming volatility in GameStop.

Note: Curious how the straddle compares to the strangle? Check out our article here! Straddles vs Strangles.

Straddles and The Greeks

Let’s conclude our article by studying how the straddle interacts with the option Greeks.

Long Straddle Greeks

Short Straddle Greeks

Remember, as stated by the OIC, short straddles have great risk!

Next Lesson

Additional Resources

Straddle Definition – Investopedia

What is an Options Straddle? | tastytrade

Long Straddle Options Strategy – Fidelity Investments

Gamma Squeeze and Meme Stocks Explained

Posted on December 7, 2021March 31, 2022 by Mike Martin

Last updated on March 31st, 2022 , 10:10 am

If you spent any time during 2021 reading about stocks like AMC Entertainment Holdings Inc (AMC) and GameStop Corp. (GME), chances are you came across the phrase “gamma squeeze”. Will the trend continue into 2022?

In a nutshell, here’s what this means.

TAKEAWAYS

A gamma squeeze causes dramatic swings in the price of a stock, almost always on the upside
A gamma squeeze is caused by traders purchasing large volumes of near-term call options
Market makers that sell these options most hedge their short-call positions with long stock in a process called “gamma hedging”
Gamma is one of the options Greeks and is the second derivative of “delta”, which is the first Greek
A “short squeeze” is the product of many traders buying back a short stock that moves against them; a “gamma squeeze” occurs only on stocks that offer options, and is caused by call option buying

Gamma Squeeze and Call Options

During the meme stock craze of 2021, retail traders were buying hoards of near-term “call options” on stocks like AMC, GME, and BBBY.

Call options are derivatives that allow traders to place leveraged upside bets on an underlying stock. Puts, conversely, allow traders to bet the same way, but these contracts profit when the security falls in value. In this article, however, we will be focusing on calls, as they are the culprits behind gamma squeezes. Let’s do a quick rundown of call options before we continue.

A call option gives the owner the right to purchase 100 shares of an underlying stock at a specific price by a specific date
Call options are bullish, meaning a purchaser expects the underlying to go up a lot in value. If the stock stays the same or goes down, long calls lose money
The expiration date for options varies widely; from days to years away (LEAPS).
A gamma squeeze results from massive near-term call option buying

So retail traders buying these short-term call options were the catalyst to numerous gamma squeezes. But in order to understand what this means, we have to look at the parties that were selling these call options to the retail traders: market makers.

Market Maker Explained

Market Maker Definition: A liquidity provider who facilitates both buy and sell orders on a particular security.

Whenever you send an order to get filled, chances are this order is routed to a market maker. If you buy 100 shares of TSLA, this market participant will sell you 100 shares of TSLA, leaving them short 100 shares of the stock.

The same is true of options.

If you were to buy 10 call contracts on GME, a market maker would sell you those contracts. You would be long 10 options; the market maker would be short 10 options.

Market makers make money by buying at the bid and selling at the offer. You can compare this profession to that of a car dealer – a car dealer buys cars at an auction, then sells the cars to you, pocketing the “spread”. Depending on the size of the trades and widths of the market, market makers can make a pretty good living.

Market Makers and Hedging

So let’s imagine you are a market maker who just sold a customer 10 call options on GME. That leaves you net short a pretty large position in a pretty volatile stock. Wouldn’t you prefer to hedge (or offset) that short option position as fast as you can? Remember, you’re after the “spread”, not market speculation.

In order to hedge their short-call options, market makers purchase stock. The goal of non-speculating market makers is to maintain a delta-neutral position. This means that they have offset all of their risks. Maintaining this neutrality is a constant battle.

A long stock position offsets a short call position. When a lot of calls are purchased, a lot of stock must also be purchased in return by market makers. This causes the stock price to skyrocket, resulting in a “gamma squeeze”.

We mentioned “delta-neutral” before. Delta is one of the option Greeks. Gamma, too, is one of the option Greeks. In order to understand gamma, however, we must first understand delta.

Let’s get started!

Option Delta Explained

Δ Option Delta Definition: In options trading, the Greek “delta” represents the amount an option price is forecasted to move in relation to a $1 change in the underlying stock price.

In options trading, the Greek “delta” allows a trader to predict how a particular option will react to a future change in the price of a security. In other words, delta offers traders a window into the future.

Like everything in options trading, the Greeks are standardized. An options delta is the amount the price of an option is expected to move in relation to a $1 change in the underlying stock.

Call options have a delta value between 0 and +1.
Put options have a delta value between 0 and -1.

Let’s take a look at a simple options chain now to see delta in action.

AAPL Option Delta Example

Type	Strike	Price	Delta	+$1 Share Price Affect	-$1 Share Price Affect
Call	147	3.25	.64	3.89	2.61
Call	148	2.63	.52	3.15	2.11
Call	149	2.11	.42	2.60	1.62

Where AAPL is trading at $148.20

The above table illustrated how the prices of various AAPL call options react to a +/- $1 move in the underlying stock.

Let’s look at the 148 call, initially valued at $2.63. If the stock price were to pop by $1 immediately, the price of this call would rise to $3.15. How did we get this number? By simply adding the delta to the previous price. Voila! That’s delta (in a nutshell).

In addition to telling us the expected move of an options price to a $1 change in the price of an underlying stock, delta also has a few more useful functions. An options delta also tells us:

The odds that an option has of expiring in the money. A delta of 0.40 has a forty percent chance of expiring in-the-money.
How many shares of stock an option “trades like”. An option with a delta of +0.60 will trade similar to 60 long shares of the underlying stock.

So now we have delta down. Let’s move on next to gamma, which is actually a derivative of delta! It’s not that confusing – I promise!

Option Gamma Explained

(Γ) Option Gamma Definition: The Greek “gamma” measures the rate at which an options delta changes in response to the price movement of the underlying stock.

In order to truly understand gamma, you must first understand delta, so make sure you mastered this Greek before we move on.

Gamma tells us how the future delta of an option will change in response to a one-point move in the underlying stock.

Before we dive into gamma, let’s look at a few of this Greek’s key characteristics:

Long Options Produce Positive Gamma; Short Options Produce Negative Gamma
Gamma is Highest for At-The-Money Options

Take a moment to study the below table.

AAPL Option Gamma Example

Type	Strike	Price	Delta	Gamma	New Delta (+$1 Share Price )	New Delta (-$1 Share Price)
Call	147	3.25	.64	.06	.70	.58
Call	148	2.63	.52	.08	.60	.44
Call	149	2.11	.42	.06	.48	.36

Where AAPL is trading at $148.20

Before, we learned that delta shows us how an option reacts to a one-point change in the price of an underlying.

Gamma goes a step further here and tells us what the future delta will be when the stock moves by one point. Gamma is known as the first derivative of delta for this reason.

By looking at the 148 call, we can see that this options delta will increase by 0.08 if the stock were to go $1 higher, and decrease by 0.08 if the stock were to go $1 lower.

Long Gamma vs Short Gamma

When a market participant buys options, they are said to be “long” gamma.

A long gamma position implies that the delta of an option(s) will increase when the stock price rises, and decrease when the stock falls.

When a market participant sells options, they are said to be “short” gamma.

A short gamma position implies that the delta of an option(s) will fall when the stock rises, and rise when the stock prices falls.

To read more about this, check out our article, “Long Gamma vs Short Gamma”.

Gamma Hedging Explained

As we said before, the Greeks are used by market makers to reduce or eliminate risk.

When traders use delta to hedge, this is called “delta hedging“. When traders use gamma to hedge, this is called “gamma hedging,”

Since delta only looks at how an options price will change in value for the next dollar move in the underlying, it has its limitations. What about the dollar after that? And so on.

Gamma hedging allows traders to offset risk for potential future large moves in the underlying and is the preferred method of hedging amongst professionals. This is why it is called a “gamma squeeze” and not a “delta squeeze”.

That isn’t to say that delta hedging isn’t used; gamma hedging is simply a more important tool. They are typically used in tandem.

GME Gamma Squeeze

Chart from Google Finance

Take a look at the above one-year chart on GameStop (GME).

During these incredible rallies, retail traders were buying as many call options as they could. Market makers were fulfilling their duty to provide liquidity by filling these orders as they came in.

This left the market makers with short-call options. As we learned, a short options position leaves a trader with “short gamma”.

Being naked short gamma in GME is a huge risk. In order to offset this risk, market makers purchased stock.

But how much stock do they need to purchase? This number was communicated to them via the Greek gamma. They were short a ton on gamma, so, therefore, had to purchase a ton of stock, thus wildly driving up the price of GME.

A gamma squeeze is a relatively rare market phenomenon, occurring mostly when short-term call buying precipitates in an uncontrollable fashion, as it did for several meme stocks.

If you’re on the right side of the market, a gamma squeeze can make you a lot of money. If you’re on the wrong side – watch out!

Sometimes, the term “gamma squeeze” gets confused with “short squeeze”. Let’s end this article by looking at the fundamental difference between these two market events.

Gamma Squeeze vs Short Squeeze

Short Squeeze Definition: A short squeeze occurs when there is more demand than supply for a security due to short positions being repurchased.

You can both buy and sell short shares of stock. When you sell a stock, you profit when the stock goes down in value. Companies with dim prospects are shorted frequently. There is no cap on how high a stock can go, therefore, short sellers of stock have infinite risk.

Take a look at the below chart of AMC stock.

AMC Short Squeeze

Chart from Google Finance

Imagine selling AMC for $20/share only to have it rally to $50/share a couple of days later. Your maximum gain was only $20 in this scenario. You would have lost more than twice what you could have made under the best-case scenario if the stock went to zero.

When you sell a stock, you do so on margin, which is essentially borrowed funds from your brokers.

If your position moves against you and you don’t have the funds to hold the position, you will enter a “margin call”. Your broker will either require you to deposit funds in your account, or they’ll take the liberty of liquidating your account for you. How do they do this? By buying the stock you are short.

When a short squeeze happens, it tends to happen all at once, creating a domino effect. This mass buying sends the stock higher. Check out this article on gamma squeeze by RagingBull to learn more.

Short selling is rooted in equity trading and traders are the cause; gamma squeeze is rooted in options hedging and market makers are the cause.

There are two ways to determine whether or not a stock is experiencing a gamma squeeze or short squeeze:

Only stocks that have options can experience gamma squeeze; if there are no options, there is no gamma squeeze.
A gamma squeeze can be confirmed by determining whether or not large call buying takes place simultaneously as the stock price rallies. The historical volume of options can be charted on most trading platforms.

As stated by the Wall Street Journal, GME’s meteoric rise wasn’t caused by a short squeeze, but by market makers hedging their short calls.

Can a short squeeze and a gamma squeeze happen simultaneously? Absolutely! It can be difficult to tell sometimes why, exactly, certain securities rise sky-high over a short period of time. However, these two rare market events are often to blame.

Next Lesson

Additional Resources

What is a gamma squeeze – IG

Anatomy Of A ‘Gamma Swarm’ – Forbes

What Gamma Squeezes Up Must Come Down – Seeking Alpha

VGT vs QQQ vs XLK: Performance and Holdings

Posted on December 2, 2021February 11, 2022 by Mike Martin

Last updated on February 11th, 2022 , 08:48 am

Information Technology ETF Comparison

	VGT	QQQ	XLK
Issuer:	Vanguard	Invesco	State Street Global Advisors
Index:	MSCI US Investable Market IT 25/50 Index	Nasdaq-100 Index	S&P Technology Select Sector Index
Category:	Small Cap, Mid Cap,& Large Cap	Large Cap	Large Cap
Dividend Yield:	0.63%	0.45%	0.65%
Expense Ratio (fees):	0.10%	0.20%.	0.12%
Number of Stocks:	340	104	77
5 Year Return:	30.87%	29.85%	28.47%
Top Holding (And Weight)	AAPL (19.35%)	AAPL (11.70%)	AAPL (22.79%)

Over the past twenty years, technology stocks have vastly outperformed the broader market. As technology tends to advance exponentially, this trend will probably only continue (if not advance) over the next twenty years.

There are three juggernaut funds that rule the ETF space within the information technology sector. Which one is best for you? Let’s get started with the comparisons right away!

TAKEAWAYS

VGT, QQQ & XLK represent the most popular ETFs in the tech space
Vanguard’s VGT has the lowest fees at 0.10%; QQQ has the highest fees at 0.20%
All ETFs have significant exposure to AAPL, with XLKs weightage coming in at 22.79% for this equity
VGT is the most diverse ETF as this fund includes small, mid & large cap stocks
Over the long-term (five years), VGT has performed the best; over the short-term (one year) XLK has performed the best

VGT vs QQQ vs XLK: Comparing Benchmarks

Let’s start with the most important comparison; differentiating what these three ETFs actually attempt (quite successfully) to track.

VGT: MSCI US Investable Market Information Technology 25/50 Index

So that’s a rather confusing name for an index! What exactly does this index track? Let’s head over to the MSCI website to see what the founders of this index have to say.

So this exchange-traded fund (ETF) includes stocks in all three of the capitalization categories (small, mid, and large). When compared to the other ETFs on our list (which only include large cap companies), VGT is the best diversified because of this.

QQQ: Nasdaq-100 Index

Invesco’s QQQ ETF is by far the most popular fund on our list. However, because of its relatively high fee nature, VGT and XLK are fast catching up! (if you’d like to check out some top tech Nasdaq 100 ETFs, read our article: Differences Between Invesco’s QQQ, QQQM, and QQQJ!)

So what index does the QQQ’s track? The Nasdaq 100. The below excerpt is taken from nasdaq.com, the founders of this index:

The Nasdaq-100 is a modified capitalization-weighted index. This means that the largest companies (AMZN, GOOGL, AAPL, etc.) have a larger weight than smaller companies. “Modifications” were put into place to assure a few companies did not dominate the index. The below lists two re-balancing contingencies put into place to assure this:

A single company is worth > 24% of the entire index
48% of the companies have a weighting of at least 4.5%

XLK: S&P Technology Select Sector Index

Unlike the QQQ’s, State Street’s XLK ETF takes its stocks from the S&P 500. This popular index can be broken down into seven unique sub-sectors. One of these sectors is technology, which is formally called The S&P Technology Select Sector Index, which the XLK ETF tracks.

So how many stocks in the S&P 500 fall under the information technology sector? 77.

The S&P Technology Select Sector Index is a weighted index. When compared to other tech indices, this index places a disproportionately large emphasis on larger corporations (which we will get into soon). If you love mega-cap tech companies, this index/ETF is for you.

VGT vs QQQ vs XLK: Comparing Fees

The average ETF fee is about 0.40%. When taking that into account, every ETF on our list charges a very low fee, or “Expense-Ratio”.

We can see that Invesco’s QQQ charges a fee that is 100% higher than Vanguard’s VGT. Should this relatively marginal difference in fee structure steer you away from the QQQs?

Maybe, but let’s first take a look at the historical performance of these ETFs. If the QQQs return an extra 1% per year, I’ll gladly pay that tiny difference in fees.

VGT vs QQQ vs XLK: Comparing Performance

The below table shows how our various ETFs have performed over different spans of time.

Rank	VGT	QQQ	XLK
1-year	34.71%	34.39%	37.14%
3-year	37.33%	34.48%	37.89%
5-year	30.87%	28.47%	29.85%

The winner here, of course, will depend upon the time frame we are looking at. VGT appears to be the long-term winner (5 years), while State Street’s XLK has performed the best short-term (1 year).

VGT vs QQQ vs XLK: Comparing Sectors

Though all of our ETFs are tech rooted, some of the sub-sectors within their compositions deviate a little outside of tech. The below images (taken from etf.com) show the top 5 sectors that every ETF on our list invests in (click to enlarge).

VGT Sectors

QQQ Sectors

XLK Sectors

VGT vs QQQ vs XLK: Top Stock Holdings

Next up, let’s examine what stocks these ETFs actually invest in. Of particular interest here is the weight that these different ETFs place on particular stocks.

Rank	VGT	QQQ	XLK
1.	Apple Inc. (19.35%)	Apple Inc. (11.70%)	Apple Inc. (22.79%)
2.	Microsoft Corp. (18.36%)	Microsoft Corp. (10.64%)	Microsoft Corp. (21.81%)
3.	NVIDIA (4.93%)	Microsoft (10.64%)	NVIDIA (7.15%)
4.	Visa (2.60%)	Tesla (6.08%).	Visa (2.87%)
5.	Adobe (2.14%)	NVIDIA (5.32%)	Adobe (2.80%)

We can see that Apple (AAPL) dominates these portfolios. However, the XLK ETF has almost twice as much exposure to AAPL as the QQQs. If you’re not very bullish on AAPL, XLK probably isn’t for you.

Final Word

So what’s the best ETF for you? From the various historical performances listed above, there does not appear to be a clear winner. All three ETFs have outperformed the S&P 500.

Additionally, it is worth noting that tech stocks tend to have more risk than a benchmark like the S&P 500.

The best hedge against risk is usually diversification. Out of the three ETFs on our list, Vanguard’s VGT ETF is the most diverse. This fund has over 300 stocks within it (QQQ has 104; XLK has 77). VGT also spans numerous market caps (small, medium, and large) while QQQ and XLK stay in the large-cap category.

But you aren’t limited to one tech fund. With most brokerage houses charging no money for commissions, why not invest in all three?

Worth noting here is the low dividends on almost all of our ETFs. Many tech companies fall into the growth category. Growth stocks tend to invest any extra income back into the company rather than pass it on to shareholders in the form of dividends.

Next Lesson

Additional Resources

VGT Vs. QQQ: Seeking Alpha

VGT vs. XLK: Head-To-Head – ETFDB

Best Tech ETFs for Q1 2022 – Investopedia

Iron Condor Options Strategy for Beginners (w/ Visuals)

Posted on November 30, 2021February 11, 2022 by Mike Martin

Last updated on February 11th, 2022 , 09:01 am

TAKEAWAYS

An iron condor consists of selling both a put spread (long put/short put) and a call spread (long call/short call) simultaneously
Both of these spreads must be of the same width and expiration
Iron condor’s profit when the options sold decrease in value
Short iron condors are best suited for market-neutral traders
Most iron condors have a greater than 50% chance of success
Maximum loss is greater than maximum profit for most iron condors
A high volatility environment allows traders to collect more premium from iron condors sold
Iron condors with 30-60 days to expiration are ideal as this time frame allows traders to profit from time decay, or the Greek “theta”

Iron Condor Definition

The short iron condor is a market-neutral options trading strategy that involves simultaneously selling both a call spread and a put spread of the same width and expiration cycle.

Iron Condor Inputs

● Short Call Spread AB

Long Call A
Short Call B

● Short Put Spread CD

Long Put C
Short Put D

Short Iron Condor Profile

Maximum Profit: Net Credit Received

Maximum Loss: Spread Width – Credit Received

Breakeven Prices: 1. Short Put Strike – Net Credit 2. Short Call Strike + Net Credit

Probability of Profit: Greater than 50%

Assignment Risk: Increases with Falling Extrinsic Value

When it comes to the more advanced options trading strategies, the iron condor is by far the most popular.

This options trading strategy is aptly named. Why? Because its profit/loss profile resembles the very wide wingspan of the condor bird.

These two “wings” each represent one spread. Since the wings go left and right, this tells us a short call spread and a short put spread are involved. When these vertical spreads are sold together simultaneously, they form the iron condor strategy.

Therefore, in order to best understand this strategy, it will first help to have mastered the “vertical spreads” options trading strategies. If you are new to spread trading, please check out our guide below before moving on.

What Is an Iron Condor?

In options trading, the short iron condor strategy consists of selling both a call spread and a put spread. In order to be a true iron condor, these two vertical spreads must have the same width (distance between their strike prices) as well as the same expiration.

The vast majority of traders prefer to sell iron condors, so this article will be focusing on short iron condors. If you instead want to be a buyer, just switch the lines and red and green profit/loss profiles in our examples around!

Short Iron Condor Components

Sell a call spread (bearish)
Sell a put Spread (bullish)

So an iron condor is selling bearish and bullish market direction. We don’t want the underlying to go up or down. Another name for this aimless direction is “market neutral”. Sellers of iron condors profit when the underlying price does not move.

A short iron condor is profitable when the stock price remains between the short strike prices of both our call spread and put spread. Take a look at the below image, which shows how this strategy performs as the stock price remains between two short strike prices.

The best way to understand options trading is by looking at examples, so let’s get into one now!

Iron Condor Trade Example

Our below trade is a “50-Point” wide iron condor with 60 days to expiration (DTE).

Trade Details

Stock Price at Trade Entry: $500

DTE: 60 Days

Call Spread: Short 550 Call for $7.89; Long 600 Call for $1.94

Put Spread: Short 450 Put for $6.15; Long 400 Puts for $0.72

Total Premium Sold: $7.89 + $6.15 = $14.04

Total Premium Bought: $1.94 + $0.72 = $2.66

Net Credit Received: $14.04 (collected) – $2.66 (paid) = $11.38

In the above trade, we netted a credit of $11.38. Don’t get too overwhelmed by all the numbers, we will be breaking them all down soon!

Since we received a net premium, this trade is therefore a credit spread. All short iron condors will be credit spreads.

Next up, let’s take a look at the profit/loss graph for this trade.

First off, let’s study the green portion of the above graph. As long as the stock stays within the bounds of both the short call and short put that we sold, we will achieve maximum profit. We said earlier that this strategy is a market-neutral strategy. Hopefully, now you can see why.

Now, what about the red-shaded areas? We can see that the losses begin to accelerate the further the stock price advances beyond both our short call and put strike prices.

Let’s compare the maximum profit and loss on this trade for a moment. We can see in the upper bounds of the Y-axis that the maximum profit is +$1,138. The maximum loss, however, is -$3.862.

So why would you risk more than you can possibly make? Because in this trade, you have a much higher chance of success than failure. Let’s take a closer look at these numbers now.

Iron Condor: Maximum Profit Potential

(Net Credit Received)

Maximum Profit: $11.38 Net Credit x 100 = $1,138

Whenever you are a net seller of options, the most you can ever make is the premium received.

We sold this iron condor for a net credit of $11.38. Therefore, our maximum profit (taking into account the option multiplier effect of 100) is $1,138.

When will this occur? If by expiration, the stock price resides between the strike prices of both of our short options. If this occurs, all of our options will expire worthless.

We sold the 450 put and the 550 call; therefore, as long as the stock closes between these two strike prices on expiration day, we’ll achieve maximum profit!

Iron Condor: Maximum Loss Potential

(Spread Width – Credit Received = Max Loss)

$50-Point Wide Spread Width – $11.38 Credit x 100 = $3,862

In order to determine the maximum loss on any iron condor, simply subtract the credit received from the width of the spread.

In our example, we are short the 450/400 put spread and the 550/600 call spread. Our spread is therefore 50 points wide. And how much credit did we take in? $11.38.

So, to determine the maximum loss here, just subtract this credit from the spread width (50-11.38), which gives us a maximum potential loss of 38.62, or $3,862 when accounting for the multiplier effect.

Losses Limited to Either Calls or Puts

Now the stock can’t be both above and below our short strike prices at expiration. In the iron condor strategy, only one side has the potential of expiring in-the-money. Let’s explore these two various outcomes now:

If the stock is below $400, the 450/400 put spread will be worth $50 at expiration while the 550/600 call spread will expire worthless. Iron Condor Value: $50
If the stock is above $600, the 550/600 call spread will be worth $50 at expiration while the 450/400 put spread will expire worthless. Iron Condor Value: $50

Maximum Loss > Maximum Profit: Why Trade?

So we have already determined that this trade has the potential to lose a lot more than it will ever make ($1,138 profit vs $3,862 loss). Why put this trade on then?

Because the odds are in your favor that the trade will expire worthless. Our maximum profit occurs when the stock is trading between $450 and $550 at expiration. That means the stock can move 10% up or down in the next 60 days (our time to expiration) and we will still achieve maximum profitability.

The below image shows this.

So will our maximum loss occur when the stock moves more than 10%? Not always. Remember, we took in a premium when we sold this trade. Taking into account this premium, the stock must move either up or down greater than 20% in order for us to have a maximum loss. When the stock breaches our short strike prices between 10% and 20%, our losses will fluctuate, but the trade will not be a maximum loss.

The below image shows this.

So we have looked at max profit and max loss; but at what prices do we breakeven?

Iron Condor: Breakeven

Since we are selling two vertical spreads, we have two breakeven points.

To determine the two breakeven prices of an iron condor, we must:

Subtract the net credit received from the short put strike
Add the net credit received to the short call strike.

Let’s next break this down, starting with the put spread breakeven.

Lower Breakeven Price (Puts):

$450 – $11.38 = $438.62

When the stock is trading at $438.62 on expiration, the 450 put will be worth $11.38 while all the other options will expire worthless. This amount is also the credit we took in, so breakeven should make sense.

Higher Breakeven Price (Calls)

$550 + $11.38 = $561.38

When the stock is trading at $561.38 on expiration, our short call will be worth $11.38 while all the other options expire worthless. Again, this is the net credit we took in, so this scenario leads to a breakeven.

Selling Iron Condors and Probability

Generally speaking, iron condors have a greater than 50% chance of success. They are known as “High-Probability” trades because of this. Understanding now that the maximum loss on these trades is greater than the maximum profit, this should make sense.

Iron Condors: Choosing an Expiration Date

Our example looked at options that had 60 days to expiration. Many iron condors that are placed have a duration of between 30-60 days. Why?

As time passes, time decay, or “theta” sets in. Option sellers love theta. The 30-60 day range allows traders to collect quite a bit more time premium than options that expire in 7 days.

For example, a one-point SPY Iron Condor expiring in 3 days is currently bid at 0.13. That same spread expiring in 17 days is bid at .39, triple the premium!

Iron Condors: Choosing Strike Prices

Deciding which strike prices you want to sell is a two-step process.

Select the call and put option you want to short
Select the corresponding options you want to buy

The width of these spreads (or the distance between the strike prices) must be the same if the trade is to be considered an iron condor.

So which options do you choose?

Start by looking at the Greek “delta”. Amongst other uses, the delta of an option tells us the odds that option has of expiring in-the-money. If an option has a delta of 0.16, it has a 16% chance of expiring in-the-money.

Now since we are selling both a call and a put, we must add these deltas together to determine the odds these options have of expiring in the money. If both of our options have a delta of 0.16, they will dually have a 32% (16%+16%) chance of expiring in-the-money. The below image shows these deltas on the tastyworks trading platform.

If the options together have a 32% chance of expiring in-the-money, they must therefore have a 68% chance (100%-32%) of expiring out-of-the-money, which is our goal being sellers!

When To Sell Iron Condors

The best time to sell an iron condor is when volatility is high. Why? The higher the implied volatility, the greater the premium you will collect. Remember, when you are a net seller of options, you want to take in as much credit as possible. Ideally, the options you sell will expire worthless, and the full premium will be collected.

As a rule of thumb, sell iron condors when:

Volatility is currently high
You expect this volatility to decrease

Final Word

The iron condor is a great risk-defined strategy for market-neutral traders.

As mentioned before, the best time to sell an iron condor is when implied volatility is elevated. As long as this volatility settles, you will probably be in good shape. Many times, however, volatility can build upon itself.

It is always wise to step back and take the general temperature of a stock (or ETF or index) before placing an iron condor. If you believe the volatility will be short-lived, you will have a high chance of success.

However, during volatile times (like the pandemic) shorts can be breached. But the best part of this strategy is its risk-defined nature. Unlike selling options naked, here, you know exactly how much you can lose.

As stated by the Options Industry Council, it is wise for traders to monitor short in-the-money options as they may be at risk of assignment.

Next Lesson

Additional Resources

Iron Condor Definition – Investopedia

Iron Condor Options Trading Strategy | tastytrade

Short Condor – The Options Industry Council (OIC)

Long-Term Equity Anticipation Securities (LEAPS) Explained

Posted on November 24, 2021February 11, 2022 by Mike Martin

Last updated on February 11th, 2022 , 09:19 am

The vast majority of options traders place trades that have a lifespan of 30-60 days. For this reason, those who utilize options are often referred to as “traders” rather than “investors”.

But not all options expire in this narrow window. Some options expire several months or even years in the future. These types of derivatives are known as long-term equity anticipation securities, or simply LEAPs.

According to the OIC (Options Industry Council), LEAP calls enable investors to “benefit from stock price rises while risking less capital than required to purchase stock.”

Although LEAPs do indeed offer less principal risk when compared to equities, the probability of success is less in LEAPs than stocks.

Because of their long lifespan, LEAPs (though still options) act more like investment vehicles than trades. Long-term options are best suited for long-term bullish (or bearish for puts) investors on an underlying stock or security.

Should LEAPs find a home in your portfolio? In this article, projectfinance will make an argument for (and against) LEAPs.

TAKEAWAYS

LEAP options have expiration dates of more than one year in the future
Long-term options are always less liquid than short-term options
The wide bid-ask spread in LEAPs is attributed to low open interest and volume
When compared to short-term options (such as front-month options), LEAPs are less sensitive to time decay
The leverage of LEAPs allows for magnified profits and losses when compared to buying the underlying stock/ETF

What are LEAPs in Options Trading?

Long-Term Equity Anticipation Securities (LEAPs) Definition: In options trading, LEAPs refer to call and put options which have expiration dates that are more than one year in the future.

There is no set time frame that defines a LEAP, but generally, options that have an expiration date that is greater than one year from the present are considered LEAPs.

Let’s take a look at how SPY (S&P 500 ETF) LEAPs appear on the tastyworks trading platform.

SPY Options Chain

We’re going to focus on the bottom portion of the above image, where LEAPs are circled in green.

Today is November 23, 2021. Some of these options don’t expire until January of 2024! We can see to the right of the month that these options expire in 787 days. That’s a lot of time!

These options are known as long-term equity anticipation securities.

We assume in this article that you have already mastered the basics of options trading. If options are new to you, check our free, comprehensive guide on the subject below!

The best way to understand LEAPs in both calls and puts is by comparing them to more popular, short-term options. Let’s get started!

Short-Term vs Long-Term Options: The "Spread"

Generally speaking, the closer an options series is to expiration, the more popular those options are. “Front-Month” (or week) options are the next to expire, and listed first on an options chain. Take a look at the below image, which shows call options on SPY set to expire tomorrow.

SPY Front-Month Call Options

What we are interested in here is the “bid-ask” spread (the two columns to the left of the “days to expiration” column).

Let’s focus on the 467 call strike. This option can currently be sold at 2.46 and purchased at 2.47. This means we can enter and exit this position right now and only 0.01 would be lost.

How do these spreads look on longer-term options? Let’s take a look!

SPY LEAP Call Options

From the above LEAP options chain, we can see the spreads for the at-the-money call options have widened from being one penny wide to $4-$5 dollars wide!

Additionally, the premiums are quite a bit higher – the greater the time to expiration, the higher the premium will be.

So what do these wide spreads mean?

If we were to buy at the ask price, and immediately sell at the bid, we would lose about $4. When taking into account the multiplier effect, that’s a $400 loss on a one lot!

LEAPs, therefore, are considerably less liquid than their shorter-term counterparts.

This liquidity problem is caused by two factors: volume and open interest.

Volume and Open Interest in LEAPs

An options volume tells us how many contracts in that particular expiration and strike price have traded all day.
An options open interest tells us how many contracts are currently in existence for a particular option.

Both of these play a huge factor in determining the bid/ask spread that we talked about earlier. The more volume and open interest an option has, the tighter its spread will be.

If you take a moment to look at these metrics in both short-term and long-term options below, you will understand why LEAPs have such wide spreads.

SPY Short-Term Options Volume and Open Interest

SPY Long-Term Options Volume and Open Interest

Let’s take a look at the 470 calls on the top options chain first.

These options will expire tomorrow; 27k contracts have traded so far today (and it’s only the morning!)

Additionally, we can see the open interest for the 470 call is 12.9k contracts.

Now, how do these metrics look on the LEAP options chain below?

Zero of the 470 strike price calls have traded today. And the open interest? 623. Compare these numbers to the ones above, and you’ll see why the markets for these two options expirations are so different.

Short-Term Options vs LEAPs: Time Decay

When you’re trading short-term options, you’re paying very close attention to time decay. Time decay is also known as “theta”, which is one of the option Greeks.

If you’re long an option that is set to expire in a few days and the underlying stock price has not been moving, your option will decrease in value.

This is bad news for long option traders. Short option traders, however, love time decay because it leads to the option falling in price.

LEAPs are not as sensitive to time decay, or theta, as short-term options. Since there is more time to expiration, the stock has a better chance of rising (for calls) or falling (for puts) to a set strike price.

Undulations in the stock price do indeed affect the pricing of long-term options, just to a much smaller magnitude than options expiring a few days, or weeks, away.

Short-Term Options vs LEAPs: Implied Volatility

So we learned above that theta is not as detrimental to long-dated options when compared to short-dated options.

But what about implied volatility? What impact does implied volatility have on the pricing of LEAPs?

Generally speaking, the implied volatility of long-term options is greater than that of short-term options. This is part of the reason why LEAPs are so expensive.

Nobody has any idea what is going to happen a year or two down the road. Market-makers, therefore, charge a premium for this uncertainty in long-term options.

As a rule, the higher the implied volatility, the greater the premium for long-term options will be.

If you want to buy a LEAP, the best opportunity will probably be during a low-volatility environment.

LEAPs: Leveraged Return Potential

One options contract typically represents 100 shares of stock. Because of this immense leverage, options offer traders the potential for huge returns, as well as losses. For LEAPs, these profits (and losses!) can be magnified.

If you were bullish on SPY one year ago today, you would have made far more money if you decided to purchase a long-term call option when compared to the exchange-traded fund (ETF) itself.

Let’s say you decided to take this risk, and you purchased a SPY DEC 16, 2022 call option one year ago today.

The below image (from the tastywork platform) shows your return on this option (click to lighten and enlarge).

SPY DEC 16 2022 Call Chart: One Year

One year ago today, the above SPY option was trading around $5. Today, that option is trading at $40. You would have netted a 700% return!

Now what if we had purchased stock instead?

SPY Stock Chart: One Year

Over the past year, SPY stock increased from $365 to $467 per share. This makes for a very attractive return of 28%.

When compared to our LEAP, however, 28% suddenly doesn’t sound too great.

This example is rare; most of the time, over the long-run, stocks/ETFs outperform options. Our example does, however, give us an idea of the great leveraged returns that options offer.

Final Word

On top of all the other types of risks that come with options trading, LEAPs introduce yet one more: liquidity risk.

If you want to trade long-term options, it is vital that you try and get filled at the mid-point.

How do you do this?

If a LEAP option is bid at $55.40 and offered at $56.50, your best bet would be to place an order (either buy or sell) at the middle point. This point would be about $55.95 (as seen below).

Getting Filled at the Mid-Point

If you don’t get filled here (and really want to be in the trade) start working that price up (if you’re buying) or down (if you’re selling) in 0.05 or 0.10 increments.

If you still aren’t getting filled, it is probably best to avoid that option.

In more liquid products (like SPY) you’ll have a better chance of getting a decent fill than more exotic stocks and ETFs.

Thanks for reading and happy trading!

Next Lesson

Additional Resources

Rolling Options – Investopedia

SPX LEAPS – Cboe Global Markets

PSDN: AdvisorShares Poseidon Cannabis ETF Explained

Posted on November 22, 2021February 11, 2022 by Mike Martin

Last updated on February 11th, 2022 , 09:22 am

The investment firm Poseidon recently teamed up with AdvisorShares to launch a new leveraged cannabis ETF: the AdvisorShares Poseidon Dynamic Cannabis ETF (PSDN).

What makes this ETF stand out in comparison to other cannabis funds is its leverage. By using swaps and derivatives, PSDN aims to apply moderate levels of leverage on up to 150% of the portfolio’s assets. This leverage will inevitably lead to more volatility. Therefore, PSDN is better suited for very bullish investors with higher risk tolerance.

Should this leveraged ETF find a home in your portfolio? For your review, projectfinance has dissected the fund’s prospectus.

TAKEAWAYS

PSDN invests in the cannabis and hemp industry
The fund is actively managed, making it more agile to market changes
Because of its active management style, PSDN charges a high expense ratio of 0.92%
PSDN is well diversified, investing in cannabis sub-sectors which include software tech, biotechnology, pharma, internet enabled devices and agriculture
PSDN will also seek opportunities from both IPOs and mergers in the cannabis space
PSDN leverages its portfolio by trading derivatives, including “swaps”

PSDN: Expense Ratio

The first thing I look at before investing in a fund is the expense ratio. Over the past few years, the fees that exchange-traded funds (ETFs) charge have been drastically decreasing.

So what does AdvisorShares/Poseidon’s PSDN charge? I found it tucked away in the bottom corner of the fund’s information page.

Management Fee: 0.80%
Other Expenses: 0.12%
Net Expense Ratio: 0.92%

The net expense ratio for PSDN is 0.92%, twice as high as the average ETF fee of 0.40%. Why do they charge so much?

Leveraged ETFs require more maintenance than passively managed funds. Because of this work that must be performed, the expense ratios on such funds are generally high. PSDN’s net fee of 0.92%, however, is extremely high.

As this ETF is brand new, we must allow some time to see if the funds performance merits such a high fee.

PSDN: Investment Strategy

The “fund objective” of PSDN is rather generic, stating they simply wish to seek, “long-term capital appreciation”.

The fund’s investment strategy, however, gives us a better idea of its unique approach.

PSDN is not, therefore, a pure cannabis play. The companies in which they invest must make half of their money from marijuana and hemp. Where does the other half come from?

What will make this fund attractive to most investors is the second part of their investment strategy: investing in derivatives. Let’s take a closer look at that next.

PSDN: Leverage Utilized

What differentiates PSDN from other popular cannabis ETFs (like CNBS and YOLO) is their proposed use of leverage.

There is little information on what derivative instruments, exactly, the fund plans on utilizing to gain this leveraged exposure. PSDN’s prospectus states that “total return swaps” will be included.

Swaps are like options contracts and futures in that they are both derivatives, but that’s where their similarities end.

Swaps are customized derivatives that trade in the over-the-counter (OTC) market
Options and futures are standardized securities that trade on public exchanges

Unlike options, swaps are private agreements between parties. Though many types of swaps are indeed regulated by the government, counterparty risk is still present. The risk with swaps is that one party may not follow through on the prearranged agreement.

PSDN: Market Sectors

The PSDN ETF includes a large range of sectors within the cannabis industry. Below are a few of the sectors on the radar of Poseidon/AdvisorShares’ fund:

PSDN: Top Ten Stocks

Poseidon’s PSDN fund currently owns around 30 stocks. This is not a very well-diversified ETF.

Additionally, the top-ten holdings comprise more than 70% of the fund’s value. Note the first security on the list: GREEN THUMB INDUSTRIES SWAP REC.

If you’re able to find out what, exactly, this represents, please let me know!

PSDN: Top 10 Holdings

Company/Security	Portfolio Weight
GREEN THUMB INDUSTRIES SWAP REC	12.19%
REC AYR WELLNESS INC	8.51%
VERANO HOLDINGS CORP SWAP REC	8.31%
TRULIEVE CANNABIS SWAP REC	8.09%
ASCEND WELLNESS HOLDINGS SWAP REC	8.08%
CRESCO LABS INC SWAP REC	6.86%
WM TECHNOLOGY INC	5.92%
CURALEAF HOLDINGS INC SWAP REC	5%
JUSHI HOLDINGS INC SWAP REC	5.40%
PLANET 13 HOLDINGS SWAP REC	5.02%

data from advisorshares

Cannabis Stocks vs S&P 500

So how does the cannabis industry stack up to the S&P 500?

If you’re going to be investing in an ETF, you’d hope that ETF has been outperforming the market -particularly when there is leverage involved.

The below image compares the one-year performance of AdvisorShares’s YOLO Cannabis ETF (blue) with the SPDR S&P 500 Trust ETF (gold).

SPY vs YOLO

Chart from Google Finance

Although cannabis stocks began the past year with a roar, they have since quieted down. A lot. The S&P 500 has easily outperformed the cannabis industry as a whole in 2021. And in 2022? Who knows what will happen.

However, I’m not sure I would want to own a non-leveraged cannabis ETF in this presently under-performing sector!

Final Word

Getting involved with leveraged securities can be a dangerous game. If you don’t understand completely what comprises a product, it is probably best to stay away. Swaps and derivatives can blow up fast. I’ve learned the hard way!

I’ll leave you with this advice.

Years ago, I was thinking about buying a cafe (I know nothing about restaurants).

I asked a restaurateur friend what his thoughts were.

“If you have to ask what you’re getting involved with,” he replied, “the restaurant business isn’t for you.”

With that being said, if you truly want to learn more about leveraged ETFs, check out our video below!

Recomended Articles

Additional Resources

AdvisorShares Poseidon Dynamic Cannabis ETF Overview – Marketwatch

5 Ways Stocks Differ From Options

Posted on November 21, 2021February 11, 2022 by Mike Martin

Last updated on February 11th, 2022 , 09:34 am

Comparing stocks to options is like comparing apples to oranges. They are completely different types of securities.

If you own a share of a company’s stock, you own a portion of that company. This comes with added benefits and rights, such as dividends and voting rights. Stock ownership is referred to as “equity“.

Options are “derivatives“, meaning their value is derived from that of an underlying stock (or ETF, or any asset, for that matter). They have nothing to do with the company – think of them as “side-bets”.

Let’s take a look at a few key options characteristics before we move on.

One options contract typically represents 100 shares of stock. This is known as “leverage” and has the potential to magnify both profits and losses quickly.
All options are either calls or puts. A long call position is bullish, while a long put position is bearish. In both types of these options contracts, a “strike price” and an “expiration date” are set.
Unlike stock, all options will eventually expire.
An options “moneyness“, (which tells us where the options strike price is in relation to the stock price) at expiration will determine whether a contract has value or not.
Stock is generally a longer-term investment. Options are shorter-term trades.

TAKEAWAYS

For long-term investors, stocks are almost always the better option.
Like stocks, options contracts can be bought or sold. The holder (owner) of an option contract has the right to either purchase stock (calls) or sell stock (puts) at the contract’s strike price.
Options are usually leveraged at a ratio of 100:1, meaning one contract represents 100 shares of stock. This leverage increases risks.
Most (not all) stocks pay dividends. Options do not pay dividends.
Both options and stocks are considered high risk. However, certain options trading strategies have considerably more risk than stocks.

Options vs Stocks

	STOCKS	OPTIONS
Ownership	Represent direct ownership in a company; can vote and receive dividends	No direct rights, but long options holders have the right to convert their contract to either long stock (calls) or short stock (puts)
Multiplier Effect	One share represents one indivisible unit of capital	One options contract typically represents 100 shares of stock
Expiry	Shares of stock (equity) never expire	ALL options contracts have an expiration date, ranging from one day to years away
Security Style	Stocks are generally long term investments	Options are generally short-term trades
Risk	Medium to High Risk	Generally high risk, but this depends upon the options trading strategy utilized

This article looks at the main differences between stocks and options. In order to truly understand these differences, you must understand the mechanics of options trading, which can take some time.

The good news? projectfinance has created perhaps the most intuitive guide out there to aid you in this process. Check out our, “Options Trading for Beginners” guide here.

For those ready to move forward with the comparison between stocks and options, let’s get right to it!

1. Ownership: Stocks vs Options

Let’s start off with one of the major differences between stocks and options: Ownership.

Ownership Rights in Stock

When you own shares of a company’s stock, you own part of that company. Being an owner comes with its benefits. Here are a few perks that come with owning equity in a company:

Perhaps the most important right on this list is the ability to receive dividends. You may not want to spend your weekends digging through the payrolls of a company of which you own 10 shares of stock, but you’ll probably want to receive that dividend.

Though dividends may seem small on paper, they really add up over time! In fact, over the past 20 years dividends have accounted for 43% of the S&P 500s historic return! Take a look at the below image from BNY Mellon.

Data from BNY Mellon Investment Management

IMPORTANT! Not all companies pay dividends! Up-and-coming growth companies tend to invest superfluous income back into the company rather than distribute it to shareholders.

Ownership Rights in Options

Options Contract Definition: An options contract gives the owner the right to purchase (call) or sell (put) 100 shares of a company’s stock at a specified price (strike price) by a predetermined date (expiration date).

Traders’ long options contracts have none of the four rights listed above for stock investors. In a company’s eye, options traders do not exist.

Why?

Options contracts are “derivatives.” These contracts are exchanged between market participants who are not involved with the company. As we saw in the definition, options contracts give the holder the right to either buy (for call options) or sell (for put options) shares of the underlying stock at a specific price by a specific date. When this happens, it is called “exercising” your option.

When a long call is exercised, it is typically transferred into 100 shares of long stock. When that happens, you have all of the rights listed above. But before this transformation occurs, you will have zero rights.

Put options, however, are transferred into short stock. Short stock (like options) has no rights.

2. Multiplier Effect: Stocks vs Options

We mentioned in the above paragraph that an option contract represents 100 shares of stock. Let’s take a closer look at that now.

Multiplier Effect in Stock

One share of stock represents one divisible unit of capital. If you want to determine what percent ownership a single share of stock represents in a company, simply divide one share of stock by the total share of stock that the company has outstanding.

Multiplier Effect in Options

One options contract almost always represents 100 shares of stock. This produces a ratio of 100:1.

You may have heard that options trading is a risky business, and you’d be right. Because of this multiplier effect, options contracts have profound leverage.

If a stock is trading at $50/share, it will cost you $50 to purchase one share.

If an options contract is trading at $2, it will cost you $200 to purchase one contract. Why is this? Because of the multiplier effect of 100! Therefore, in order to determine the true cost of an options contract, you simply need to move the decimal point of the quoted price two places to the right.

3. Lifespan of Stocks vs Options

Next up, let’s take a look at the different lifespans of stock and options.

Stock Lifespan: Potentially Infinite

Stocks have no listed expiration date. Over time, most companies will eventually go bankrupt, merge, or get bought out, but these events are often unseen. Some companies have been around for a very long time. State Street Corporation, for example, has been around since 1792!

Options Lifespan: Finite and Predetermined

Unlike stock, every single options contract has a predetermined expiration date. If by this date your long call or put option is “out-of-the-money”, it will expire worthless and you will have lost the entire premium paid.

As time passes and the underlying stock price drifts away from the strike price of an options contract, time decay will set in. This is known as “theta”, and is the reason why most beginner options traders are unsuccessful. Theta is one of the option “Greeks” which traders use to help manage risk.

It is true some options contracts are more long-term, with Long-Term Equity Anticipation Securities (LEAPS) having lifespans of more than two years. However, no option contract spans centuries, like many stocks do,

4. Investment Style: Stocks vs Options

Stock traders and options traders frequently have different investment philosophies.

Stocks Are Investments

Generally speaking, the mindset of stock investors and options traders is vastly different. Most people who purchase stock do so with the intent of holding the position long-term, riding the ups and downs of the company’s profits and losses, hoping, somewhere down the road (maybe years), to sell that stock for a profit.

Stock inventors generally utilize the “set it and forget it” method. After purchasing a stock, they don’t have to check the position every day, nor do they have to manage it. They just sit back, collect dividends (sometimes), and hope the price appreciates.

Option Are Trades

This is different for options traders. Why?

We mentioned before that all options have a strike price and an expiration date. If the underlying price moves away from an options strike price, a trader will need to take maintenance action to 1.) avoid further losses or 2.) avoid being “assigned” (for short options positions).

Over the long run, stock investors tend to outperform options traders. However, this isn’t always the case. The success of an options trader depends dually upon that trader’s savviness as well as a certain amount of luck.

Why luck?

Generally speaking, we have a better idea about what is going to happen to the price of a security over the long term. If you believe in Apple, buying shares of AAPL may very well pay off in the long-term. But what’s going to happen tomorrow at AAPL headquarters? Nobody can foresee this.

Because stocks don’t expire, they have the ability to ride out short-term volatility. Options? Not so much.

5. Risk: Stocks vs Options

Last up, let’s take a look at the fundamental risk profiles of both stocks and options.

Stocks Are High Risk Investments

When compared to treasuries, bonds, and money markets, stocks are considered risky assets.

So stocks are indeed risky. When you diversify your stock positions across numerous companies, however, this risk can be mitigated. Exchange-traded funds (ETFs) offer a great way for investors to diversify.

However, everything is relative. When comparing stock investing to popular options trading strategies, the former is indeed less risky in nature.

Options Are VERY High Risk

Options trading is an intricate and complicated world. There are indeed options trading strategies that you can put together that lower your overall risk when compared to stock. But this article is focused on the more popular strategies such as buying calls and puts.

When compared to buying stock, buying options is riskier.

This is a wide assumption and made from an “overall” viewpoint.

In theory, however, options typically have less principal risk than stocks.

Why?

A call option on AAPL is going to cost you a lot less than buying 100 shares of AAPL stock (which is the amount one options contract represents). Therefore, your total principal risk when trading options is less than that of stock! Check out the graph below, which shows how the max loss on stock is greater than a call option (where you will only ever lose the premium paid).

However, over time, time decay (AKA “theta“) sets in, and long options often lose money. AAPL stock probably won’t go to zero; an out-of-the-money call bought on AAPL, on the other hand, probably will go to zero.

Additionally, notice in the graph how the stock needs to move up quite a bit for a long call to breakeven (yellow dot). Breakeven here is determined by strike price + premium paid.

With stock, breakeven occurs the moment you purchase (or sell) the security.

Final Word

Buying a share of stock is one of the simplest ways to invest. You click a mouse button, and voila, you’re filled. All you need to do is (hopefully) collect dividends, and wait for the price to appreciate.

Options trading can get extremely complicated. Huge sums of money are made and lost every day in the options markets. If you’d like to learn more about options trading, check out our guides below!

Next Lesson

Additional Resources

Difference Between Options and Stocks – Fool.com

Getting Acquainted With Options – Investopedia

Options vs. Stocks | Ally

Options Trading Explained

Call Options Explained

Call Outcome #1: Maximum Loss

Call Outcome #2: Profit

Put Options Explained

Put Outcome #1: Maximum Loss

Put Outcome #2: Profit

1.) Time Decay Risk

2.) Volatility Risk

Implied Volatility per Expiration

3.) Dividend Risk

4.) Pin Risk

5.) Memory Risk

Final Word

Next Lesson

5 Ways Stocks Differ From Options

Call Options vs Put Options Explained: The Complete Guide

Option Moneyness: In The Money, At The Money and Out Of The Money

Additional Resources

Index Options: European Style

Index Options: Cash-Settled

Index Options: Tax Advantages (60/40)

Normal Taxation

Index Option Taxation

Index Options Eliminate Tracking Error

Index Options Pay No Dividends

Popular Index Options List

Final Word

Next Lesson

SPX vs SPY Options: Here’s How They Differ

5 Reasons VXX and VIX are NOT the Same Products

Implied Volatility Explained (The ULTIMATE Guide)

Additional Resources

Recommended Video

What is Implied Volatility?

Implied Volatility and Extrinsic Value

Option Buying/Selling and Implied Volatility

Implied Volatility vs Historical Volatility

Implied Volatility and Probability

Implied Volatility is Annualized

Expected Range Formula

Expected Range Example

1 Standard Deviation Explained

2 Standard Deviation Explained

Low IV vs High IV

IV Rank and IV Percentile

Implied Volatility Rank

Implied Volatility Percentile

IV Rank vs IV Percentile: Which is Better?

S&P 500 IV vs IV Rank

S&P 500 IV vs IV Percentile

Final Word

Implied Volatility FAQs

Next Lesson

Option Greeks Explained: Delta, Gamma, Theta & Vega

Gamma Squeeze and Meme Stocks Explained

Trading Earnings With Options

Additional Resources

Long Straddle Explained

Long Straddle Components

Long Straddle Example Trade

Long Straddle Chart

Long Straddle Maximum Profit

Long Straddle Maximum Loss

Long Straddle Break Even

Short Straddle Explained

Short Straddle Components

Short Straddle Example Trade

Short Straddle Chart

Short Straddle Maximum Profit

Short Straddle Maximum Loss

Short Straddle Break Even

Short Straddle: The Expected Move

TSLA Options Expiring in One Day: Stock at $2,965

Straddles and The Greeks

Long Straddle Greeks

Short Straddle Greeks

Next Lesson

Short Straddle Study: 11 Years of Data

Iron Condor Options Strategy for Beginners