A diagonal spread may be a strategy you would like to implement into your trading arsenal. Today we will discuss how a diagonal spread is created. We will also reveal some of the advantages and disadvantages of a diagonal spread.

A diagonal spread is a strategy which occurs when two options are bought or sold. These two options use the same instrument. These two options are of the same type, either two calls or two puts. The two options are at different strike prices, as well as two different cycles of expiration.

When a long diagonal spread is initiated, it can either be a net debit or a net credit to your account. A long diagonal spread consists of an option which you buy with more days to expiration than the option which you sell with less days to expiration. The strikes which are bought or sold to create the diagonal spread will determine if the spread is a debit or credit.

**An Example of a Bullish Diagonal
Spread **

A bullish diagonal spread can be composed by buying an in-the-money call option far out in time. Then, you would sell an additional call option with a dissimilar strike price which is usually a little out-of-the money, along with a closer expiration date.

Below is a risk graph of an example of a Call Diagonal Spread on SPY. This position has a bullish bias.

**Figure A. SPY Call
Diagonal Spread from Think or Swim**

The setup for the bullish diagonal in Figure A is as follows:

- Purchase an in-the-money call, 376 days to expiration. The call purchased is the June 19 2020 280 strike.
- Sell a slightly out-of-the-money call, 45 days to expiration. The short call is the July 19 2019 289 strike.

If you are able to keep an eye on your trade more often, you could explore selling shorter term options which could result in more opportunities to sell multiple cycles using the same long option. Of course, you do have more gamma risk with weekly options. Each cycle that you sell and are able to accrue a profit will lower the cost basis of the long call purchased.

**How a Bearish Diagonal Could Be
Constructed …**

Now let's look at the setup for a bearish diagonal. Figure B below is an example using SPY.

Figure B. SPY Put Diagonal Spread from Think or Swim

The example shown in Figure B above is a setup for a bearish diagonal spread; meaning you think SPY will move down. The setup for this diagonal is as follows:

- Purchase a long term in-the-money put, 376 days to expiration. The put purchased is the June 19 2020 295 strike.
- Sell a slightly out-of-the-money put. The short put is the July 19 2019 284 put.

**The diagonal can also be used in a
similar manner as a covered call.**

A covered call can tie up a lot of capital, because you have to purchase at least one hundred shares of stock to create the basis for a covered call.

A diagonal can help to diminish these capital requirements.

For example, a diagonal spread could be created by buying an in-the-money call option 12 months or more in the future. This call option would immediately have intrinsic value due to it being in the money.

Using the above SPY example in Figure A, SPY is trading at $288. The call purchased in this example is the Jun 19 2020 280 call, which has $8.00 of intrinsic value because it is in-the-money by $8.00. The long option would be a type of stock substitute, as compared to purchasing 100 shares of stock which would be required for a covered call.

Due to buying the option further out in time, which in this case is 12.5 months, there will be some time premium added to the price of the option. Most of this options' premium or cost will be the intrinsic value and the rest will be time value.

Using this same example, the $280 SPY option strike cost was $22.82 and $8.00 of the premium for the option is the intrinsic value. The other $14.82 of the premium, or cost of the option is the time value of the option.

**What is the maximum profit potential of
a diagonal spread?**

The exact maximum profit potential in a diagonal spread can't really be calculated because of the position is using two expiration cycles. However, to give you an idea as you analyze a potential position the profit potential can be estimated with this formula:

- For a bullish call diagonal spread, the width of the call strikes, less the net debit paid, is the approximate maximum profit.
- For a bearish diagonal spread using puts, the same formula applies … the width of the put strikes less the debit paid equals the approximate profit.

**What is the breakeven of diagonal spreads? **

Once again, the exact breakeven cannot be calculated because of the different expiration cycles of the options in the spread. To give you an idea, however:

- For a bullish call diagonal, the approximate breakeven can be calculated by taking the price paid for the long call, plus the net debit paid.
- For a bearish diagonal spread using puts, the same formula applies … take the price paid for the long put, minus the net debit paid.

**Some Key Facts about Diagonal Spreads
…**

Many traders use diagonal spreads as directional strategies. In this instance, your goal when entering the trade is for the price of the instrument to trade to the short strike option you sold, but not to go beyond the short strike. If the price of the instrument crosses above the short strike of the option you sold, you may want to roll the option out in time and out in price. Or, you could close the short option position before expiration day, if the option has gone in the money. Keep in mind, however, if you choose the keep the position open and the short has gone in-the-money, you run the risk of assignment.

To learn more about assignment in options trading, read the article published on February 3, 2019. The article can be found here: https://aeromir.com/00395/understanding-assignment-in-options-trading

If you are looking to join a trading group where traders of all experience levels share their trades and provide excellent feedback, look no more, join Aeromir today!

If you have any particular trade strategies incorporating diagonal spreads and would like to share, feel free to do so below.

]]>Every trader is intimately acquainted with risk. Trading both stocks and options has large potential for rewards, but also risks. In order to sustain a successful trading career, a trader must be willing to accept risk. The basic rule of thumb I was taught many years ago when I first started trading was “never trade with money you can't afford to lose.” There are no guarantees in trading that any position will yield a perfect reward. As a trader, you settle for the probabilities and potentials, and manage risk accordingly. Having said that, however, by predefining the risk you can afford to sustain, you can avoid making mistakes that jeopardize your entire trading account, and career.

Most traders are always trying to locate new strategies that offer healthy rewards with minimal risk. It is only with trading experience that you are able to easily assess the risk of a particular strategy and use it to your advantage. But, the basic rule of thumb remains the key to successful trading: Never take on the risk unless it's worth the return.

**What are the two types of risks? **

Basically, there are two types of risks – the known and the unkown. Each time you place a trade, you are putting the risk of that trade on the line. This is a known risk, because it involves a specific amount of money. The unknown risk that is lurking in the market can take on many forms. Everything from economic or political news, earnings, and natural disasters can have some effect on the market, creating this unknown risk.

**Risk is not viewed the same by every
trader…**

One trader's perspective of risk may be viewed as irrational thinking by another. Risk is relative, but to the person who perceives it in a given moment, it is absolute and beyond question in his/her mind.

**Understanding and accepting risk is
the most important aspect of trading **

There isn't any element of trading that is more important than having a true understanding of risk; how to accept it and how to manage it. Accepting risk means that you are able to accept the outcome of your trades without emotional despair or fear. It doesn't do any good to take on the risk of entering a trade if you fear the consequences; doing so means that you have not taken on the full understanding of risk.

The more successful traders not only take on the risk without any trepidation or fear, but experience has taught them to actually embrace that risk.

*“When you genuinely accept the risks, you will be at peace with
any outcome”.* Mark Douglas

Having a complete understanding and the willingness to accept risk does not happen overnight; it evolves over time as you fine-tune your trading skills. It all starts as you develop your trading plan and identifying those strategies and associated risk level that work in conjunction with your account size, and trading style. The full understanding and acceptance of risk does not come immediately to a new trader; it is developed over time with experience back testing, paper trading, and trading live starting with small positions. As you learn to identify the risk associated with each and every trade, you will be more prepared to accept the inherent risk that goes along with trading, and eventually embrace that risk.

Risk/ratio is widely used by traders and financial professionals all over the world when analyzing a trade or investment. Basically, risk/reward measures the amount of reward expected for every dollar at risk. The risk/reward with complex options strategies can be useful to analyze positions to determine the relationship between the risk and reward.

**Here is a very simple example of how
risk/reward is calculated …**

Let's say a friend asked you to lend him $25. In return for your agreeing to the loan, your friend agrees to pay you back $50 in two months. The reward (payback amount of $50), divided by your risk (amount of the loan of $25) equals the risk/reward ratio. In this scenario, you would have a 2:1 risk/reward ratio. You are risking $25 for a potential reward of $50.

**Why is it important for options
traders to calculate the risk/reward ratio?**

Calculating the risk/reward ratio before entering a new position is an exercise most professional options traders perform on a regular basis. This habit can help you make a better decision in your trading. Sometimes, it may be surprising to see that the risk/reward ratio of some strategies that you feel are a “win/win” strategy are actually quite unfavorable when the math is worked out. Calculating the risk/reward ratio before entering a position can help avoid potentially unprofitable trades that are not immediately obvious. Many traders can also make it their own personal policy to only trade positions where a certain risk/reward is met. Some traders have as high a risk/reward ratio of 4:1 as their “threshold”, although a ratio of 2:1 is commonly used by retail traders as this ratio “theoretically” gives the trader the potential to double their money.

Let's look at some examples of a few options trades and the risk/reward ratio associated with each of them.

**Bullish Call Spread on XYZ Company**

XYZ is currently trading at $12, and you have a bullish bias. You purchase a call debit spread, +10 strike/-$15 strike at a cost of $1.50. The maximum profit of the spread is $3.50 ($5, which is the width of the spread, minus the cost of $1.50). If XYZ closes at $15 above expiration, the full profit can be realized of $350 (less commissions).

Risk/reward ratio: $3.50 divided by $1.50 = 2.3, or a risk/reward ratio of 2.3:1.

**Iron Condor on ABC Company**

You enter a 10-point wide Iron Condor on ABC Company and receive a credit of $1.25. The maximum potential profit of the trade is $1.25 (credit received), as long as ABC Company remains within the two short strikes. Your total risk is $875 ($1,000 for the 10-point wide wings, less your credit of $1.25).

Risk/reward ratio: $1.25 divided by $875 = .14, or a risk/reward ratio of .14:1.

In this second example, this type of risk/reward ratio is considered by many traders to be unacceptable; where you are risking $875 to potentially only make $1.25.

Many options trades look and sound good at first glance. Sometimes, inexperienced traders may fall into the trap of not achieving their anticipated returns after entering a position even though the underlying is performing as they expected. The reason for this may be that they did not understand the true risk/reward at trade entry. Traders who have a full understanding of their risk, and the risk/reward of every trade before entering it can make a more informed, intelligent decision on which strategy to implement in order to maximize their profit potential.

If you are looking for a trading group where traders of all experience levels share their trades and give excellent feedback, look no more.

I hope this article serves as a refresher on risk and risk/reward. If you have would like to add anything you have personally found helpful in your trading regarding risk, feel free to comment below.

]]>Two stocks with options which are about the same price are not always equal. Volatility is one of the reasons two stocks with a similar underlying price may actually have very different values for their options. Volatility can be a useful tool to determine which underlying you would like to incorporate into your trade plan.

The level of volatility can also help to determine the type of strategy you may want to use to possibly increase your probabilities of obtaining a profit.

Volatility measures how risky the underlying stock is in regards to market uncertainty or how much it moves in price. Volatility can sometimes be difficult to determine, and is the one part of the option pricing model which can vary the most.

When an underlying stock has higher volatility, you can expect a greater move in either direction. Higher volatility can also lead to a higher price for both put and call options, which will be noticed mostly with the at-the-money options. There is the most uncertainty with the at-the-money options, so there is more volatility.

Before I get into an example of how volatility levels can affect the prices of options, let's review the definition of intrinsic and extrinsic value of options. On August 17, 2018, we published an article on this subject; the article can be found here: https://aeromir.com/00182/what-are-intrinsic-and-extrinsic-option-values

**To
summarize the article:**

The Intrinsic
Value of an option is the price the underlying is currently trading minus the
strike price. If the value which is
calculated is a negative number, then the intrinsic value is zero*.*

The Extrinsic value of an option is many times referred to as “the time value”. The time value is one of the primary elements which affects the premium of an option. The formula to determine the extrinsic value of an option for both the calls and the puts, is:

*Current option price minus the Intrinsic value =
Extrinsic Value*.

The extrinsic value is higher in options with higher volatility when comparing two similarly priced underlyings. The extrinsic value of an option is the time portion of the option. The extrinsic value is highest with the at-the-money options. As you move further in-the-money or out-of the-money, the extrinsic values decrease.

**Let’s look at an example on two
underlyings that have similar prices:**

GLD and DATA have about the same underlying price. GLD is currently trading at 122.42 and has a volatility of 8.93%. DATA is currently trading at 121.86 with a volatility of 34.21%. DATA has higher volatility, whereas GLD has lower volatility. GLD, with lower volatility, will have lower priced options than DATA, the higher volatility stock with options.

The difference in volatility of the two stocks will be reflected mostly in the extrinsic value of an option’s price. As I mentioned in the summary of the article published last August, extrinsic value is determined by taking the price of an option and subtracting its' intrinsic value.

In-the-money options have intrinsic value. Remember that intrinsic value is determined for a call option by taking the current stock price minus the strike price. With a put option, the intrinsic value is determined by taking the strike price minus the current stock price.

Take a look at Figure A which is below. GLD stock price is 122.42. Now take the 31 May 120 strike call option and subtract it from the current stock price of 122.42 (122.42 minus 120 equals 2.42). Therefore, the 31 May 120 strike call option for GLD has an intrinsic value of 2.42. This is the amount the 31 May 120 strike call option is in the money, or the intrinsic value. The bid/ask spread of the 31 May 120 call strike for GLD is 2.65 to 2.70. If you average the bid/ask spread, you get the value of the call to be 2.675. So the GLD 31 May 120 calls are trading for about 2.675. Since the option’s current value is 2.675, then 2.42 of the option premium is the intrinsic value. So most of the premium in the calls is intrinsic value.

Figure A GLD Option Chain Intrinsic/Extrinsic Values/ Volatility @ 14.10%

*Next, let's review
extrinsic value *

As stated previously, extrinsic value is determined by taking the price of an option and subtracting its' intrinsic value. Look at Figure A again. The price of the 31 May 120 call option we determined to be approximately 2.675. The intrinsic value we determined to be 2.42. Take 2.675 minus 2.42 and you get .255, which is the extrinsic value of the option.

**Now let's look at DATA 31 May Option
Chain in Figure B below……**

Figure B DATA Option Chain Intrinsic/Extrinsic Values/ Volatility @ 34.21%

Both GLD and DATA are trading at about the $122.00 price level. The volatility for DATA is 34.21%, which is higher than the GLD volatility level of 8.93%. So you would expect the option price to be higher for DATA than GLD.

Let’s take a look and see if this is true. The 31 May 122 call option strike price for DATA is about 3.40 (average of the bid/ask). The 122 call option strike price for GLD is about 1.16. As you can see, there is a large difference between the values of the two options. The higher volatility of DATA makes the value of the 122 call option much more than the value of the GLD 122 call option.

The volatility of the underlying affects the pricing of the options. In these two examples, the market makers are pricing in more premium for the DATA options because it is more volatile. The market makers are factoring in more extrinsic value, or time premium, because DATA is more volatile than GLD.

*It is important to
track and be aware of the levels of volatility of the underlying stocks you
trade.*

If you are looking at two stocks with an underlying price about the same, you may think the options would be priced about the same. This is not true many times. It is important to look not only at the stock price of an underlying, but also the volatility. The above examples illustrate how two stocks trading at about the same price can have option values that are quite different.

Hope this helps you in your trading decisions.

Feel free to leave a comment below.

]]>ETFs (Exchange Traded Funds) have increased in popularity among traders of all types since their introduction in the early 1980's.

In a nutshell, Exchange Traded Funds (ETFs) are funds that track indexes such as the S&P 500, NASDAQ, Dow Jones, Russell 2000, etc. When an investor buys shares of an ETF, they are buying shares of a portfolio that tracks the yield and return of the related index. By purchasing an ETF, investors get the diversification of an index fund, at a much lower cost. Some ETF shareholders are also entitled to a portion of the profits sometimes paid quarterly, such as dividends.

At the time of their introduction, one of the primary intentions of ETFs was to give investors low cost, liquid exposure to widely followed broad market benchmarks such as the S & P 500, Dow Jones Industrial Average, etc.

As the number of ETFs offered has increased over the years,
so has the number of ETFs devoted to specific sectors of the market. **These
are called Sector ETFs**, and there are hundreds available to traders which
are in some very specific segments of the market. These sector ETFs include industries such as,
but not limited to, biotechnology, homebuilders, leisure, retail, financials,
and health care.

Sector ETFs are a class of exchange traded funds that invest in the stocks and securities of a specific market sector. For example, the Financial Select SPDR ETF (XLF), is comprised of 62 underlying securities that operate in the financial sector and represented in the S & P 500 index.

The use of sector ETFs can help traders diversify their portfolio, while at the same time reduce the market risk of purchasing individual stocks in a particular market segment. For example, buying a financial sector ETF may allow a trader to feel more comfortable about trading in the financial market, rather than buying one or two bank stocks.

Some of the best known sector ETFs and their current prices are shown below:

- Financials (XLF) Current price: $28
- Technology (XLK) Current price: $78
- Consumer (XLY) Current price: $119
- Health Care (XLV) Current price: $89
- Industrials (XLI) Current price: $77
- Retail (XRT) Current price: $45

**Sector ETFs can be appealing for
traders with smaller trading accounts …**

The lower price of the sector ETFs means that less capital is required when trading these vehicles as compared to SPY or QQQ (currently $292 and $189, respectively). The reason is that the higher the price of the broad market ETFs such as SPY or QQQ, the higher the price of their options, all other things being equal. The profit potential relative to the capital requirement is the same for both, so the lower priced ETFs may be more suitable for a trader with limited capital.

To illustrate the price differences between a sector ETF and a broad market ETF, let's use the example of a trader who is considering placing a straddle on some type of ETF in advance of a news event. The news event is expected to significantly move the market in that industry. For this example, the trader is taking a position surrounding a major product announcement by AAPL that is likely to rock the technology sector. We will look at a straddle on the Technology Sector (XLK), as compared to a comparable position on QQQ. QQQ is the ETF that tracks the companies in the NASDAQ 100 index, which is heavily weighted with technology stocks.

**Figure A. QQQ Straddle **

**Figure B. XLK Straddle **

Figure A shows the straddle position on QQQ set up 49 days to expiration, for a cost of $8.92. The comparable position, a straddle in the technology sector XLK, can be entered at this time for a debit of $3.92, significantly less than the QQQ position. The graphs are similar as far as the risk/potential reward.

**In addition to sector ETFs devoted to
individual industries, there are families of sector ETFs that cover the full
universe of stocks that make up a specific index…**

** These families include:**

- Market Weight Sector ETFs

Market weight sectors are based on the standard market capitalization indexes and their underlying instruments. One of the largest families of market weighted sector ETFs are the Barclays iShares Dow Jones Sector ETF (IYY) iShares Dow Jones Sector ETF. This ETF covers the full sphere of securities that are in the Dow Jones US Index.

Market weight sector ETFs can be appealing to a trader who is looking for exposure to the broad US market. For the most part, they are slanted towards the larger-cap stocks, without much exposure to small cap stocks.

- Equal Weight Sector ETFs

The term “equal weight” means that all stocks have a similar weighting in the index, regardless of the company's size. In an equal weight index, each security affects the overall performance of the index equally; there is not one stock that is more heavily weighted than another. Equal weight sector ETFs may outperform a market weight fund when small cap stocks are performing better than large cap stocks.

Each sector ETF in this family is rebalanced quarterly to maintain the equal weighting.

An example of an equal weight ETF is the Invesco S & P 500 Equal-Weight Sector ETF (RSP), which is based on the S & P 500.

- Fundamentally Weighted Sector ETFs

This is a somewhat new type of index. Fundamentally weighted sectors are a type of ETF in which components are elected based on fundamental criteria as opposed to market cap. They can base their structure on a variety of fundamentals such as price, earnings, revenue, etc. A popular example of this type of ETF is the FTSE RAFI US-1000 Index (PRF) Fundamentally weighted ETF PRF. They have gradually been increasing in popularity among investors looking for a longer term, passive investment.

- Leveraged Sector ETFs

While leveraged sector ETFs provide another opportunity for exposure to the specific market sectors, they also have higher exposure to changes in price and volatility of the underlying index. For example, using a leverage factor of 2:1, if a sector index moves up 1%, the corresponding leveraged sector ETF would by up 2%. This works the same in reverse … if the sector index drops by 1%, the corresponding leveraged ETF would go down 2%. Leveraged ETFs are often used for short term strategies, rather than a “buy and hold” type of investment. ProShares Ultra QQQ (QLD) is an example of a leveraged sector ETF which tracks the NASDAQ 100 Index Leveraged Sector ETF.

**In summary …**

Sector ETFs provide a liquid, relatively low cost, method for a trader to add diversification to their portfolio. Rather than invest in stocks for a particular industry, sector ETFs can provide less risk than purchasing stocks in that industry. They allow a trader with a strong conviction about a particular market sector to gain exposure without having to choose individual stocks.

It may be worth considering the use of sector ETFs in your own trade plan. As with any instrument you consider trading, It is wise have a full understanding of all the benefits – and risks involved – in order to help you make informed decisions on your trading.

Are you looking for a mentoring program, trading group, or a group of like-minded traders to share both positive and negative trade experiences? Look no more, join today!

]]>The decisions of millions of investors and traders affect the price movements in the options market. There are many useful statistics in addition to price movement that indicate what other market participants are doing. This article will focus on two factors many traders consider when trading options; daily trading volume and open interest.

**Trading Volume**

Daily trading volume represents the number of option contracts being exchanged between buyers and sellers. This exchange identifies the level of activity for that option contract. Volume can give you insight into the strength of the direction of the current market for the option's underlying stock/index. It is important to remember that trading volume is relative, and needs to be compared to the average daily volume of the underlying. A large percentage change in price, accompanied by larger-than-normal trading volume, is a good indication of the strength of the direction of the price move. On the other hand, large percentage increases in price accompanied by small trading volumes are less likely to indicate a market direction. That combination (large increase in price with low volume) may indicate that a reversal is forthcoming.

As mentioned above, for every buyer, there is a seller … the transaction between the two counts toward the daily volume.

Here is an example of trading volume in a put option XYZ at the strike price of $75 which did not have any contracts traded on a specific day. The trading volume is zero. The next day, a trader buys 10 put options and a market maker sells 10 put options – the total trading volume for that day is 10.

Volume is important when doing technical analysis, as it gives you important information about market movement. Traders view volume as an indicator of the strength of a trade – the higher the volume, the more interest there is in the underlying. Therefore, higher volume leads to more liquidity, so it can be easier to enter and exit a position more quickly. Volume, however, is relative. It needs to be compared to the average daily volume of the underlying.

**Open Interest**

Open Interest** **is a concept that can sometimes be confusing, especially to novice traders. Although it is usually one of the default data fields on most brokers' option chains – along with bid price, ask price, volume, and implied volatility – some traders ignore open interest. It is often considered less important than the option price, or current volume, Open interest provides some useful information veteran traders take into consideration when entering an option position.

Open interest will tell you the total number of each option contract that is currently open (in active positions). This includes contracts that have been traded, but not yet liquidated by either an offsetting trade, an exercise, or assignment. When you are looking at open interest of a particular option, you cannot tell whether the options have been bought or sold.

Using the same example of a put option XYZ at the strike price of $75; on a particular day 5 option contracts were bought, and 5 option contracts were sold. The open interest for this option is now 5.

An option's open interest decreases when buyers and sellers of options close out their positions. An option's open interest increases when investors put on new long positions, and when sellers put on new short positions.

One way to use open interest is to look at it relative to the volume of option contracts traded in any particular day. When trading volume is greater than the open interest, it is indicative that trading activity in that particular option was exceptionally high that day. In general, the higher the open interest, the easier it will be to trade that option quickly and at good pricing.

Below is an option chain for the underlying SPY showing the volume and open interest for various strike prices for the May 17, 2019 expiration cycle. This visual will give you a feel of the difference between the two.

Figure A. SPY Option Chain

**What are some differences between trading volume and open interest?**

- While trading volume is updated constantly throughout the trading day, open interest is calculated only once a day, at the close.
- An option's trading volume can only increase, whereas an option's open interest could either increase or decrease. Unlike an option's trading volume which includes contracts being bought and sold, open interest shows only the amount of contracts that are held.
- Volume of options can only increase, while open interest can either increase or decrease.

**So why is Open Interest an important factor in option trading?**

When you are looking at the total open interest of an option, there is no way of knowing whether the options were bought or sold – which is probably why many option traders ignore it altogether. One way to use open interest is to look at it relative to the volume of option contracts traded. When the volume exceeds the existing open interest on any given day, this suggests that trading in that particular option was exceptionally high that day. Open interest can help you determine whether there is unusually high or low volume for any particular option.

Open interest also provides information regarding the liquidity of an option. If there is no open interest for an option, it may be harder to get decent fills on a trade entry or exit. When options have large open interest, it means there are a lot of buyers, and sellers, which can result in an easier fill at a good price.

**Summing it up …**

- Volume and open interest both reflect the activity level and liquidity of options.
- Volume refers to the total number of completed trades. Hence, volume is a good measure of strength and overall interest in a particular option.
- Open interest reflects the number of option contracts held by traders in positions; whether they have been bought or sold.

We all know that trading is more of an art than a science.

A measure of what other traders are doing can be a valuable tool in your trading business. Daily trading volume and open interest are useful indicators to enhance your trade entries, and exits, at the best price and fastest execution.

Are you looking for a trading group, a mentor, or a place to share your trade ideas? Look no more, join today!

If you have additional thoughts on how volume and open interest help in your options trading, feel free to comment below.

]]>**How the VVIX can be Used as a
Barometer in Trading**

Most traders are familiar with the VIX, which measures the volatility of the S & P 500. The VIX was introduced in 1993 by the Chicago Board of Options Exchange. The index measures the 30-day forward volatility of a combination of put and call options on SPX. The VIX is also sometimes referred to as the “fear index” by investors.

Today we will talk about another instrument that measures volatility, the VVIX. The VVIX is a measure of the expected volatility of the 30-day forward price of the VIX. Basically, the VIX gives an indication as to whether SPX option prices are rising or falling. The VVIX is often referred to as “the VIX of the VIX”.

**How is the VVIX calculated?**

The VVIX reflects the prices of a range of both at-the-money and out-of-the-money VIX options. The actual calculation entails three steps:

1) Locate expected variances relative to different option expiration cycles for the VIX.

2) Incorporate a variance for 30 days forward.

3) The last step is taking the square root of that number (calculated in steps #1 and #2) and multiply by 100 to express the VVIX as a percent.

The prices for VVIX are updated every 15 seconds, and its term structure set at each day's close. The VVIX term structure is plotted on specific expiration cycles. For example, June 2019 measures the expected volatility of prices in the June 2019 VIX futures.

Below is a one year, daily chart of the VVIX from Think or Swim. For comparison purposes, the VVIX chart (black line) is compared with the VIX for the same period (red and green line).

**Figure A. One year VVIX chart (black line) compared with VIX (red and green line)**

As you can see from Figure A, there is some correlation of price action between the VVIX and VIX. This correlation is closest at extreme values. According to the Cboe (Chicago Board of Options Exchange), historically the long term mean price of the VVIX is 86.

Below is a six month chart of the VVIX, which shows the index currently at 82.94, slightly below the long term mean.

**Figure B. Six month chart of VVIX showing the current
price of VVIX at 82.94**

The long term mean price of the VIX is 24. Below is a six month chart of VIX, which indicates the current value (12.88) is below the mean.

**Figure C. Six month chart of VIX **

The VVIX is considered high by many traders when it is over 100 to 110. When the VVIX is at its mean (86) or lower, it is an indication that overall market volatility is low.

**What are the similarities and
differences between the VIX and VVIX?**

- Both the VVIX and VIX measure implied volatility of options 30 days to expiration. The VIX measures the implied volatility of the S & P 500 Index; the VVIX measures the implied volatility of the VIX.
- The calculation for the two indexes is the same; except the VVIX is calculated using VIX option prices, and the VIX is calculated using SPX options.
- Option premium prices will be relative for both: When VIX is higher, SPX options prices will be higher, all else remaining the same. This same logic applies to VVIX. When VIX option premiums are higher, VVIX will be higher, again all else remaining the same.

**How can traders capitalize on high and low levels of the
VVIX?**

Traders can benefit from observing the levels of the “VIX of the VIX” because it provides useful insight into VIX futures and options prices. These observations can bring to light:

- The expected volatility of the VIX.
- The expected volatilities that influence the inclination of options prices on the VIX for varying expiration cycles.
- VVIX can give a general idea of market confidence in the future values of the VIX.

Many traders who observe the levels of the VVIX, along with the VIX, choose to place option trades on the VIX itself. A few choices based on various levels may include:

- If both VIX and VVIX are trading near the high end of their historical ranges, well above the mean, a trader may consider entering a call credit spread on the VIX, because the potential for both VIX and VVIX to revert back toward their historical mean is relatively high.
- If both VIX and VVIX are trading at the lower end of their historical ranges, a trader may want to consider purchasing a long call or a call debit spread in the VIX, and that strategy would perform well if and when the VIX and VVIX rises.
- If both VIX and VVIX are at the mid-point of their historical means and a trader believes there is not a substantial move apparent in either direction, he/she may consider placing an Iron Condor trade on the VIX. If the VIX continues to remain stable without a big move, this type of position would benefit.

In summary, regardless of what particular trade strategy you have in your portfolio, the VVIX is a very useful tool that many traders stay abreast of. Even if you choose not the trade VIX options based on the levels of the VVIX in correlation with with levels of the VIX, price action of the VVIX may serve as an additional alert in your trade plan to call attention to changes in the volatility environment. This may indicate it is time to adjust or exit an existing positon, or present an opportunity to enter a new position based on your market bias.

If you have found monitoring the VVIX helpful in any particular way and would like to share, feel free to comment below.

Are you looking for a mentoring program, trading group, or a group of like-minded traders to share both positive and negative trade experiences?

Look no more, join today!

]]>Pairs trading is generally considered a market neutral strategy. Some traders use the strategy as a directional strategy. Pairs trading is one of many approaches a trader can use to reduce risk.

The strategy often combines a long position with a short position, using a pair of highly correlated assets. A pairs trade can use any two assets. Many times traders use assets such as two stocks, two exchange traded funds, two currencies, two commodities, two options, or two futures.

Any number of combinations can be used in pairs trading. Some examples are the FTSE verses the DAX, NDX against S&P 500, FedEx vs United Parcel Service, Home Depot vs. Lowes, etc.

Often these markets move together. A trader looks for some type of correlation between the two assets. The two assets will not be completely correlated. When there is an up or bullish day, both assets generally go up in price. The same goes if there is a bearish day, both assets will generally go down in price.

Controlling risk is very important. A pairs trade must be constructed within the guidelines of the trader's risk tolerance.

**Today’s example refers to pairs
trading as a market neutral strategy using stock.**

Pairs traders using stock as the underlying asset often look for a variation in the correlation between the two assets. A trader may elect to enter long on the asset which they feel will rise in price. At the same time, they will short the asset which they feel will go down in price.

In a market neutral strategy, the profit on a pairs trade is realized from the difference in the price change between the two assets. The relationship between the two assets has changed, resulting in a profit or loss.

**Profits using stock as the underlying
asset can accrue if:**

- The long asset increases more than the short asset.
- The short asset decreases more than the long asset.
- The long asset goes up, and the short asset goes down.

A pairs trader can realize a profit in many different market climates and volatilities.

Because the strategy pairs one asset in correlation to another asset, it reduces market exposure. This tends to produce a hedge against market risk.

The market neutral pairs trade takes away some of the market risk because the risk is applied to the relationship between the long and short asset and not the overall market.

A market neutral pairs trade is not concerned with which direction the market moves, so directional risk is less. The profit is realized by the difference in price change between the two assets and not the market itself.

**Divergence in a Pairs Trade …**

Some traders will enter a pairs trade when there is divergence. Divergence can be caused by a big move in one asset while the other asset does not move much in price. Sometimes both assets will move in opposite directions which cause divergence.

If the trade is entered on a divergence basis, the trader would be hoping that the correlation between the two assets will revert back to the mean.

**Figure A. Chart showing the
relationship of GOOG and /NQ. **

In figure A the green and red line depicts the price movement of GOOG. The purple line depicts the price movement of /NQ.

Divergence is the difference in the price plot of /NQ and GOOG is indicated on the chart in Figure A.

This divergence for some traders indicates a good entry point for a pairs trade.

The trader could enter the position with the hope that /NQ and GOOG would revert back to the mean.

**A trader can construct a directional
pairs trade.**

To do this, the trader would determine the ratio between the two assets. From the ratio, the position can lean towards the directional bias of the trader.

For example, a trader feels XYZ stock at a price of 100, is more bullish than ABC stock with a price of 50. XYZ stock has a 2 to 1 ratio when compared to ABC stock. Therefore the position is weighted bullish on XYZ stock.

**How does a trader calculate the ratio
for the two pairs?**

The ratio for each asset in a pairs trade is calculated by determining the notional value of each underlying asset.

The notional value is important because a trader needs to know how much leverage is being controlled. This is helpful in the event the trade goes against the trader. It helps to define risk.

**How to determine the notional value
of a futures contract… **

A futures notional value is equal to the dollar value of one futures contract.

The future /ES $ dollar value is $50. Let’s say the current price of ES is 2800.

To calculate the notional value, multiply the dollar per point which is 50, times the current price which is 2800. This equals the notional value of $140,000.

**Pairs trades can be constructed using
stocks and futures. **

Let’s use /NQ and GOOG as an example. The futures symbol for the Nasdaq is /NQ.

Let’s say NQ is currently trading at 7180.00 and GOOG is trading at 1166.00.

To determine an approximate 1 to 1 ratio for /NQ and GOOG, a trader would divide 7180 by 1166. This equals 6.15. Therefore the approximate one to one ratio would be 1 contract of /NQ and 6 contracts of GOOG.

1 contract: NQ = 7180.00

6 shares GOOG= 6996.00

**What are Some Advantages of Pairs
Trading?**

- Market neutral strategy – The spread or difference between the two assets can be traded.
- The strategy can also be traded directionally.
- In general there is less volatility in the trade.
- The trade can be scaled to help offset some of the risk.

**What are some Disadvantages of Pairs
Trading?**

- Controlling risk can be hard at times.
- Margin on the trade can be high. Two assets are being traded so there is margin on each asset.
- Commissions can be costly due to two assets.
- Execution can be challenging- partial fills and slippage can occur.

**In Summary…**

The subject of pairs trading is enormous. This article has given you some insight of the world of pairs trading.

Pairs traders often look for an opportunity where the two instruments are acting in an abnormal relationship to each other. When this relationship begins to fail, pairs traders can buy long the instrument, which is performing weakly, and short the instrument which is performing strongly. Once the relationship of the two instruments returns back to its statistical norm, the trade can be closed.

Pairs trades can also be executed directionally.

Determining the correct ratio of a pairs trade is important. From the ratio, a trader can build the position according to the determined directional or neutral bias.

There is a very good Round Table discussion on ViPars. This is a pairs trading strategy. Go to Round Table with Scott Ruble | Introduction to ViPars.

Let’s us know how you trade pairs…

Be part of the community.

We love learning from each other.

Good Trading…

]]>Moneyness is a common term which is very important when looking at an option chain. Moneyness in an option chain refers to the relationship of where the price of the underlying is currently trading and the strike price of the option within the option chain.

If this is the first time you have heard the term Moneyness, the term may sound funny to you. But, it is one of the basic concepts of option valuation. Knowing and understanding Moneyness will help you to interpret the information within an option chain.

**What is an Option Chain…**

An option chain is a display or listing of all the call and put option prices, along with their corresponding premiums, for each expiration period. Each option chain can supply the bid-ask quotes of each strike price of the option in each expiration period. Using the bid-ask quotes allows a trader to estimate the premium of the option at each strike price and expiration period in the option chain. A trader can usually get a fill on an option order somewhere between the bid and ask price in the option chain.

**Figure A. NKE Option Chain**

Figure A shows an option chain of NKE. The underlying price is 86.42 as shown at the top left of the option chain. The strike prices, and the bid-ask spread for both the calls and puts, are shown below using the 29 March 19 expiration cycle.

**Understanding the Language of
Moneyness…**

Traders will often refer to an option as being In-The- Money (ITM), At-The-Money (ATM), or Out-Of-The Money (OTM). Other terms traders use are Near-The -Money, or Close-To-The-Money. This terminology is very important in reference to an option chain. Moneyness helps a trader to understand what the information in the option chain is showing.

**What is an In-The-Money Option (ITM)…**

When the strike price of a call option is below the current trading price of the underlying equity, it would be referred to as In-The-Money (ITM). As an example, a 86.00 call strike option contract would be ITM if the underlying equity price is 86.01 or greater. The equity must be trading above the strike price of the call option in order for the call option to be In-The-Money.

In Figure A, the price of NKE is trading at 86.42. The 86.00 strike call option is currently ITM. To determine how much the 86.00 strike call is ITM, take the current price of NKE (86.42), and subtract the 86.00 call strike of the option, which equals 0.42.

A put option would be ITM when the strike price of the option is above the current trading price of the underlying equity. In Figure A, let’s use as an example the 87.00 put option. The put option strike would be ITM if the current price of the underlying is below the strike price of the put option. Since the current price of NKE is trading at 86.42, and the put option strike price is 87.00, the put option is 0.58 ITM. This is calculated by taking the strike price of the put option (87.00) and subtracting the current price of NKE (86.42), which equal 0.58.

**What is an Out-Of-The-Money Option (OTM)…**

When the strike price of a call option is above the current trading price of the underlying equity, it would be referred to as Out-Of-The-Money (OTM). As an example, a 87.00 call strike option contract would be OTM if the underlying equity price is 87.01 or greater. The equity must be trading below the strike price of the call option to be Out-Of-The-Money.

In Figure A, the price of NKE is trading at 86.42. The 87.00 strike call option is currently OTM. To determine how much the 87.00 strike call is OTM, take the call option strike price 87.00 and subtract the current price of NKE (86.42), which equals 0.58.

A put option would be OTM when the strike price of the option is below the current trading price of the underlying equity. In Figure A, let’s use as an example the 86.00 strike put option. The put option strike is OTM if the current price of the underlying is above the strike price of the put option. Since the current price of NKE is trading at 86.42, and the put option strike price is 86.00, the put option is 0.42 OTM. This is calculated by taking the current price of NKE (86.42) and subtracting the 86.00 put option strike, which equals .42 OTM.

**What is an At-The-Money Option (ATM)…**

When option strike price is the same as the current price of the underlying, it is At-The-Money (ATM). An ATM call or put strike option is equal to the current price of the underlying.

**What is a Near-The-Money Option …**

When the price of the underlying is in close proximity, but not exactly equal to the strike price of the option, it is many times referred to as being near-the-money or close-to-the-money.

**What Determines the Value of an
Option at Expiration?**

In-The-Money options have value because of their premium. If the option is In-The-Money, it can be exercised. If the option strike is ITM by only one cent, it will have value at expiration.

As an example to illustrate the value of an option at expiration, a trader bought a 86.00 strike price long call option which expires 29 MAR 19. The option expired, and NKE closed at 87.00. The trader who bought the 86 strike price long call option which expired on 29 MAR 18 realized a profit of 1.00. The option expired 1.00 In-The-Money, which created the 1.00 profit.

OTM options will only have value because of their premium. Since they are Out-Of-The-Money, they cannot be exercised. If an option strike expires just one cent out of the money it will be worthless.

**In Summary … **

Moneyness is a term which you as a trader will often hear mentioned. Now that you have more of an understanding as to what In-The-Money, Out-Of-The-Money, At-The-Money and Near-The-Money means, it should be easier for you to know what fellow traders are talking about. If an option strike expires In-The-Money at expiration, it will have value. An ITM option can be exercised. If an option strike expires Out-Of-The-Money at expiration it will have no value. An option that is Out-Of-The-Money cannot be exercised.

If you are looking for a trading community that has a wide variety of programs including one-on-one mentoring, educational classes, and interactive trading groups, look no more. Join today!

Please leave a comment below if you would like to add to the conversation.

]]>One of the myriad of strategies available to traders are credit spreads. Two popular types of credit spreads are the Bear Call spread and the Bull Put spread. Today's article will cover the basics of these spreads … how they are constructed, how much can be gained, as well as the risk involved and how much capital can be lost.

**What is a
Credit Spread?**

Credit spreads are made up of two options with two different strike prices. One option strike is bought for a debit, and the other option strike is sold for a credit. This results in a net credit for the spreads. Both options are in the same expiration period.

Credit spreads often take advantage of time decay, also called theta. Theta is the measurement of how much the value of an option will lose or gain each day as it gets closer to expiration. Knowing the potential time decay can allow you to use the decay to develop your strategy.

Time decay is not linear – the theoretical rate of decay accelerates as the option gets closer to expiration. The best way to explain time decay is to show a visual. The graph below (courtesy of tradermentality.com) shows how time decay/theta increases as the option approaches expiration.

Figure A. Time Decay Graph (courtesy of tradermentality.com)

**Let's talk
about these two popular types of credit spreads:**

**Bear Call
Spreads explained …**

The bear call spread, or call credit spread, is generally used when a decline in the price of the underlying is expected. It is constructed by selling a call option at a specific strike price, while at the same time purchasing the same number of calls at a higher strike price (further out-of-the-money), in the same expiration cycle.

Bear call spreads can be used many ways. Two examples are a stand-alone position, or as a hedge for a current position.

Below is an example of a bear call spread on MSFT opened 61 days to expiration, with the price of MSFT at 105.99.

**Figure B. Bear Call
Spread on MSFT**

The bear call spread in Figure B was opened as follows:

- Sold (5) 115 Calls at 2.16 credit
- Bought (5) 120 Calls at 1.07 debit.

Net credit: 2.16 credit less 1.07 debit = $1.09 credit per lot, or $545 total credit for the 5-lot position.

**How much profit
or loss is in this Bear Call Spread?**

If you entered this position and chose to take it to expiration with the expectation that MSFT will remain below the short call strike of 115, you would enjoy the full profit of $545, less commissions. Taking spreads to expiration presents a risk many traders choose not to have in their trading plan. However, the point of this example is to show the maximum profit potential for the spread.

Next, how much could potentially be lost on this position? Because the credit spread is five points wide (each point equates to $100 margin x 5 points = $500) and there are 5 contracts, the gross margin for the position is $2,500. A credit of $545 was collected when the trade was opened, reducing the overall margin requirements to $1,955 (Gross margin of $2,500 less credit received of $545). The total risk, or total loss potential, is $1,955 plus commissions.

**What about the expiration breakeven?**

The expiration breakeven in Figure B is calculated by taking the short strike of 115 plus $1.09 credit received which equals $116.09. (Note that Think or Swim is showing $116.08 on Figure B; most likely due to rounding of the prices in the calculation.)

**Bull Put Spreads
explained …**

The Bull Put spread is often used when a trader expects a rise in the price of the underlying. It is constructed by selling a put option at a specific strike price, while at the same time purchasing an equal number of puts at a lower strike price in the same underlying and the same expiration cycle.

Bull Put spreads can also be used in several ways; two of them being as a stand-alone trade, or as a hedge for a current position.

Below is an example of a Bull Put Spread on MSFT opened 61 days to expiration, with MSFT selling at 105.99.

**MSFT Bull Put Spread**

The bull put spread was opened as follows:

- Sold (5) 97.50 Puts @ $2.32 credit
- Bought (5) 92.50 Puts @ $1.38 debit
- Net credit: $.94 per lot, or $470 total credit for the position ($94 x 5)

**How much profit
or loss is in this bull put spread?**

If you entered this position and chose to take the spread to expiration expecting MSFT to remain above the short put strike of 97.50, you would enjoy the full profit of $470, less commissions. However, as with the calls, taking spreads right to expiration can be outright dangerous at times so it is not a strategy generally employed by conservative traders.

The potential loss on the position is calculated in a similar manner to the bear call spreads. Because this spread is five points wide (each point equals $100 of margin x 5 points = $500) and there are 5 contracts, the gross margin is $2,500 . A credit of $470 was collected, reducing the overall margin requirement to $2,030. So, the potential loss if a trader did nothing and MSFT gapped below the expiration breakeven, the entire $2,030 loss would be realized ($2,500 less $470 credit) (plus commissions).

The expiration breakeven is calculated by taking the short strike of 97.50 less $.94 credit = $96.56 as shown on the graph in Figure C.

**Where to place the short strike in a credit spread …**

It is a trader's choice where to place the short put in a vertical credit spread when opening the trade, depending on your market opinion and strategy for the position.

There is a balance between the risk:reward with regards to the placement of the short strike. The closer the placement of the short spread is to the price of the underlying, the better the credit will be. However, going along with the higher potential reward is the greater risk of getting into trouble. On the other hand, when the short strike is placed farther away from the money the credit will be lower. The lower credit also lowers the potential risk of the position.

**Summing up
Credit Spreads …**

Vertical spreads such as the Bear Call and Bull Put Credit Spreads offer traders a limited risk strategy, along with a limited profit potential. This strategy can be used by directional traders as well as traders who see the underlying trading in a range.

Both types of spreads can be used as a position/portfolio hedge if you are expecting a major market move in either direction.

The Bear Call and Bull Put Spreads can also be combined to create an Iron Condor, a popular non-directional strategy that we will cover in an upcoming article.

As always, it is important to back test any new strategy thoroughly and begin with a very small number of contracts when you are ready to begin with live capital.

If you would like to learn other ways spreads can be used, you might want to listen to this informative webex:https://www.youtube.com/watch?v=knYrmO76LdE&feature=youtu.be

Are you looking for a mentoring program, trading group, or a group of like-minded traders to share both positive and negative trade experiences? Look no more, join Aeromir today!

]]>**Today you will learn about a basic synthetic option position called the synthetic long stock position.**

You can create a synthetic long stock position to replicate and replace buying stock outright. You also can create a synthetic short stock position to replicate and replace selling stock outright.

A synthetic long stock position is created when you purchase one at-the-money call option and sell one at-the-money put option at the same strike price and same expiration cycle. The position represents buying 100 shares of the underlying.

If you would like to create a larger position, the call and put options must be at a one to one ratio.

Both the synthetic long stock and the synthetic short stock strategy have the potential to reduce margin requirements for you.

A synthetic long stock position can be entered as a debit or a credit. Whether or not you pay a debit or receive a credit to enter the position can depend upon where the price of the underlying is trading in relationship to the option strike price you are using to create the position.

**A Risk Graph is helpful to visualize
the similarities between traditional long stock and synthetic long stock…**

A Risk Graph shows many important items. One of those items is how the movement of the price of the underlying will affect the underlying’s value.

Do you want to learn more about the risk graph? If you do, here’s a risk graph tutorial from Think or Swim.

To understand the relationship between a traditional long stock position and a synthetic long stock position, let’s take a look at a risk graph showing each position.

Here’s a risk graph of AAPL traditional long stock…

**Figure A: 100 shares AAPL Traditional Long Stock**

This risk graph is showing the price of AAPL is currently 193.90. Let’s assume you purchased the stock at the current price 193.90.

If the underlying price increases, it will be indicated on the diagonal red line. If the underlying stock stays above the 193.90 the stock position will show a profit.

If the underlying moves down below the 193.90 entry price, the long stock position will show a loss. This loss will be indicated on the red diagonal line.

You must include your commission costs to determine your actual profit or loss.

**Here’s an example of a synthetic long
position…**

Figure B: AAPL Risk Graph Synthetic Long Stock Position

This is a risk graph showing an AAPL synthetic long stock position. This position was created by purchasing an at-the-money 21 DEC 18 195 long call option and selling an at-the-money 21 DEC 18 195 put option.

As you can see, both options have the same strike price and the same expiration cycle.

Please notice the diagonal line which indicates the profit and loss of the stock.

Do you see how the synthetic long option position has a similar risk profile when compared to the 100 shares of AAPL risk graph in Figure A?

**How is a Synthetic Long Stock Option
position constructed?**

At the same time at the same strike price and the same expiration date;

- Buy 1 at-the-money (ATM) Call option
- Sell 1 at-the-money (ATM) Put option

**How to calculate the profit of a
synthetic long stock position is shown below:**

There is unlimited profit potential up to the expiration date of the options.

- If the position is entered as a debit:

Profit = Underlying Price minus Strike Price of the Long Call minus the net debit you paid if the trade was entered as a debit minus commissions.

**For Example:**

110 (underlying price) – 105 (strike price) – $2 (debit paid) – $1 (commissions)

= $2 (profit)

- If the position is entered as a credit;

Profit = Underlying Price minus Strike Price of the Long Call plus the net premium/credit you received minus commissions.

**For Example:**

110 (underlying price) – 105 (strike price) + $3 (credit) – $1 (commissions)

= $7 (profit)

**What is the potential risk in a synthetic long stock position?**

Just as a traditional long stock positon, there is risk to you if the price of the underlying goes down after you have entered a synthetic long stock position.

If the underlying price goes to zero and the option cycle expires, you would lose all the money you paid to enter the position.

You will lose when the underlying price is lower than the strike price of the short put option.

**How to calculate the potential loss
of a synthetic long stock position is shown below:**

- If the position is entered as a debit:

Potential Loss = Strike price of the short put option minus the price of the underlying plus the net premium you paid plus commissions.

**For Example:**

105 (strike price) – 100 (underlying price) + $3 (debit) + $1 (commissions)

= $8 (loss)

- If the position is entered as a credit:

Potential Loss= Strike price of the short put option minus the price of the underlying minus the net credit paid plus commissions

**For Example:**

$105 (strike price) – 100 (underlying price) – $3 (credit) +1 (commissions)

= $3 (loss)

**What are the breakeven
points for a synthetic Long Stock Position?**

- If the position was entered as a debit:

Breakeven Point = Strike price of the long call option plus the net premium paid to enter the position plus commissions.

**For Example:**

$105 (strike price) +$2 (debit) +1 (commissions) = 103 (breakeven)

- If the position was entered as a credit:

Breakeven Point = Strike price of the long call option minus the net credit received to enter the position plus commissions.

**For Example:**

$105 (strike price) – $3 (credit) +$1 commissions) = $103 (breakeven)

**Synthetic split-strike positions can
also be created…**

Synthetic long stock and synthetic short stock positions use at-the- money strike calls along with the same expiration at-the-money strike puts.

Synthetic split-strike positions can also be constructed and are discussed a little bit in this article:

**Are Synthetics the same as owning
stock?**

One of the key differences between buying stock outright and creating a synthetic stock position is: an option has an expiration date of which you must be aware. It will expire. Stock does not have an expiration date.

If you own stock that pays dividends, you receive those dividends. If you create a synthetic position, you will not receive dividends. Options do not pay dividends.

In the United States, stock which you hold for a certain period of time may have tax advantages. A synthetic option position does not receive those same tax advantages.

**Simulate buying or selling indexes
using a synthetic long stock position.**

Indexes such as RUT and SPX do not allow you to purchase the underlying outright.

You can create a synthetic position using options, which would be identical to buying or selling the underlying.

If you want to create a long position to simulate buying the index, you would buy an at-the-money call option and sell the at-the-money put option using the same strike price and same expiration.

If you want to create a short position which would simulate selling the index, you would buy the at-the-money put option and sell the at-the-money call option using the same strike price and same expiration.

**Key Takeaways**

- The synthetic long stock strategy is a bullish position.
- To create the position, purchase a call option and sell a put option at the same strike price in the same expiration cycle.
- The synthetic long stock strategy replicates buying 100 shares of stock.
- Maximum profit is unlimited.
- Maximum loss occurs if the stock goes to zero.
- One advantage to the synthetic long stock strategy is the margin requirements could be less than purchasing 100 shares of stock.
- An option has an expiration date of which you must be aware. It will expire. Stock does not have an expiration date.

If you have found a particular synthetic long stock position to be helpful or a hindrance in your trading please comment below. We can benefit from each other’s experiences good or not so good.

]]>