Volatility levels are widely used by traders when making a decision to enter or exit a position. Understanding the differences between the various metrics of volatility can help gauge option pricing, and can be essential in your efforts to be more consistently profitable in your trading.

Implied Volatility Percentile (IVP) or Implied Volatility Rank (IVR) are two tools which can be used to track historical volatility. Using these tools will show you where the current IV number is in relationship to what volatility has been in the past.

When you learn to use the relationship of the current implied volatility and compare it to historical volatility by using either IV percentile (IVP) or IV rank (IVR), you will have an edge in your trading for many strategies. When you compare IV to IVP or IVR, it is important to use IVP consistently or IVR consistently. Comparing the current IV to both IVP and IVR can lead to confusion. It is important to either use IVP or IVR. Using IVP one time and IVR the next time is not recommended. Stay consistent.

When you look at the implied volatility (IV) of an option, it is reflecting the current IV. It is important to understand the relationship of the current volatility to the past historical volatility. This will help to determine what type of trading strategy to use when you enter a trade.

The can give your trading an edge.

To start, let's review the basics of Historical and Implied Volatility

**What is the definition of Volatility?**

**Historical Volatility**is a measure of past performance. Because it allows for a more long-term assessment of risk, historical volatility is widely used by traders and market analysts in the creation of investing strategies. Historical volatility is also referred to as realized or statistical volatility. For the purpose of this article, I am using current IV percentile as historical/statistical IV. IV Rank is another method to determine historical IV which you will also learn about in this article.**Implied Volatility (IV)**is the estimated volatility of a particular stock/index. IV is a calculation which reflects the current volatility. In general, implied volatility increases when the market is bearish, when investors believe that the underlying price will decline over time. Generally, implied volatility decreases in a bullish market, when investors believe the underlying price will rise over time. If there is a sharp move upward in price, there are instances when short term volatility may increase.

**How can Implied Volatility affect Options Traders?**

**Implied volatility is one of the key factors in the pricing of options.**Options give you the opportunity to purchase or sell an underlying at a specific price during a pre-determined period of time. The higher the implied volatility, the more premium the option will have. The less the implied volatility, the less the option's premium.**Knowing the relationship between implied volatility (IV) and current IV percentile**can allow you to determine if an option is more inexpensive or expensive…**Implied volatility has the biggest effect on the amount of extrinsic value in the price of an option.**When IV increases, the extrinsic value of both calls and puts increases. This makes the call and put option prices more expensive. When IV decreases, the extrinsic value of both calls and puts decreases. This makes the option prices less expensive. If you would like to read more about the intrinsic and extrinsic value of options, here is an article published on August 17, 2018: Intrinsic and Extrinsic Value of Options

**An option's value is determined by the following components:**

- Stock Price
- Strike Price
- Time to Expiration
- Volatility
- Interest Rates
- Dividends

Five of these components are easy to determine. They are basically fixed. The one which is unknown is volatility. As volatility goes up or down, it can reflect significant changes in the price of an option. Two of the most important components of an option's price are volatility and time to expiration. These two components can greatly affect your overall profit and loss. When you purchase an option, it is not enough to be right on market direction. You also have to be aware of time decay, volatility, and the relationship of current IV to its historical IV.

** What is IV Percentile?**

Implied Volatility Percentile (IVP) can provide traders with an additional metric to help gauge the pricing of options. IVP will tell you the percentage of days over the past year that implied volatility traded below the current level.

To explain IVP, let's start by looking at the current implied volatility using the S & P 500 Index as an example.

The one year chart of SPX is shown below, showing the current implied volatility of 21.67%.

Figure A. One Year SPX Chart indicating current Implied Volatility

Below is a screenshot taken from the Think or Swim option chain.

Figure B. Today's Options Statistics from Think or Swim

One way to find Current IV and IV percentile on the Think or Swim platform is to scroll down to the bottom of the option chain and look for Today's Options Statistics. It shows the Implied Volatility of 21.67%, as well as the Current IV percentile at 34%**. **

The current IV Percentile is calculated by taking the number of trading days the IV of SPX was below its current level and dividing it by 252 (the number of trading days in a year). The current IV Percentile in this example is 34%.

Using this example with IVP at 34%, the understanding can be that implied volatility of SPX traded below the current implied volatility of 21.67% for 34% of the past year, or about one-third of the year. This indicates that SPX IV was below 21.67% for about one third of the year. For two-thirds of the year, the implied volatility was above the current level of 21.67%.

This means that the current IV of SPX in relationship to its historical past is in the lower one third region. Therefore, option prices will be less expensive or “rich” than if the current implied volatility was at higher percentage.

**How do you know if the IV of an option is high or low in relationship to itself?**

**Here is an example:**

Stock ABC ‘s current price is currently trading at 50. The implied volatility of the stock is 20.0%, and the IV percentile is at 80%. Looking at an implied volatility of 20.0% you, would probably think the current IV was on the lower side.

Look at the Implied Volatilty Percentile. It is at 80%. What does this mean to you? It means over the past year 80% of the time ABC’s current IV was below 20.0%. This indicates ABC options are probably costly due to the current implied volatility of 20.0% relationship to the implied volatility percentile of 80.0%.

Remember, the current IV of 20.0% was lower 80% of the time over the last year. This shows the current IV to be high. This will make options more expensive or “rich”.

**Implied Volatility Rank is yet another volatility metric that many traders take into account when making their trading decisions…**

Implied Volatility Rank (IVR) can tell you whether the current implied volatility is high or low based on the IV over the past year. It is an average of the highest high and lowest low volatility for the past 52 weeks. Other time periods can be used such as 30 days with some trading platforms.

Let's use the same SPX example for one year to calculate IVR. The 52 week IV high was .468, and the 52 week IV low was .088. The formula used for a one-year IV rank is as follows:

Figure D. IV Rank Formula (photo courtesy of www.projectoption.com)

To calculate the one year IVR, look at the options statistics in Figure 2.

With SPX IV currently at 21.67%, the IV Rank would be calculated as follows:

Current IV (.2167) minus 1-Year IV Low (.088) = .1287

1-Year IV High (.468) minus 1-Year IV Low (.088) = .38

.1287 divided by .38 = IV Rank of .338 or 33.8%.

This IV Rank of 33.8% indicates that the current IV and the low IV is only 33.8% of the entire IV range over the past year. This means the current IV is closer to the low end of historical levels of implied volatility.

At the extreme levels, an IV rank of 0% means that the current IV is at the lowest point of the one-year range, and an IV rank of 100% means the current IV is at the highest point of the one-year range.

**How can you take advantage of the relationship between current Implied Volatility and IV Percentile or IV Rank?**

You can base the type of trade you place using Implied Volatility, IV Percentile and IV Rank. As you know, there are risks and rewards with every type of trade. A few strategies for consideration using high and low volatility levels are:

**High Volatility Could Indicate Opportunities to Sell**

You expect volatility to decrease, thus the option you sell could decrease in price, making it profitable.

**Credit spreads.**When you sell a credit spread, you will receive a higher credit when volatility is high.**Iron Condor.**When you sell an Iron Condor, you will also receive a higher credit when volatility is high.- When you buy a
**Butterfly**in a high volatility environment, your position will benefit as volatility drifts down, as long as the underlying price stays close to your short strike.

**Low Volatility Could Indicate Opportunities to Buy**

You expect volatility to rise, therefore, the option you buy could become worth more.

**Long put or put debit spread.**This trade can allow you to lower your cost and benefit from a spike in volatility.**Long Calendar spread.**This trade could benefit from the back month volatility increasing while the front month options decay.**Iron Condor.**The Iron Condor tends to perform better in higher volatility markets, but can still do well in lower volatility markets.

When you base your trade strategy on the relationships between Implied Volatility, and IV Percentile, and IV Rank, it does not guarantee that your trade will be profitable. However, it does give you a tool to use for your trade entries and exits so volatility can have a chance to work in your favor.

Do you have a trading method using volatility you would like to share? Please feel free to comment below.

]]>Today you will learn about the risk reversal. It can be used to protect or hedge your stock, position, or portfolio. A risk reversal can be useful to guard against a major market move. Risk reversals can also be used as a directional position.

A risk reversal can be structured so you do not have to take on a lot of risk.

A risk reversal is a position that makes use of a call and a put option, or a call spread option and a put spread option. This can change or flip the risk of the position from bullish to bearish or vice versa. The risk reversal is sometimes referred to as a combo.

Risk reversals are very flexible, and can be a good tool to use for your trading.

**How the Risk Reversal got its’ Name…**

Legend has it that large institutions that were long stock and wanted to hold the stock when the market moved against them, would buy put options and sell call options to provide a hedge.

The risk reversal would offset the loss on the long stock if the stock continued to fall in price. To help pay for the option that was bought they would sell a call option to collect premium. It was a good method to temporarily get some short delta without upsetting the portfolio of stocks they owned.

They were reversing the risk of their long stock. Therefore, the market makers began to call this strategy a “risk reversal”.

**Here’s a risk graph showing AAPL Long Stock…**

** **

**Figure A. 100 Shares of AAPL Long Stock**

To understand how a risk reversal works, it is important to know what a risk graph looks like showing a long stock position.

AAPL is trading at approximately 203.00.

The red line on the risk graph indicates as price goes up, the value of the stock will increase.

The red line on the risk graph also indicates as price goes down, the value of the stock will decrease. There is unlimited risk to the downside.

The margin to enter this position is $20,311.00

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

**Here’s a risk graph showing a long stock position with a risk reversal…**

** **

**Figure B. Long 100 Shares AAPL with a Risk Reversal using short call and long put**

Figure B is showing that the price of AAPL is approximately 203. The risk reversal is constructed by buying a 195 put option and selling a 210 call option.

The risk reversal is entered for a net credit of .10 less commissions. As you can see, the long stock is protected and has limited risk to the downside. The upside potential profit has been reduced because a call option has been sold.

The margin to enter this position is $20,293.00.

**Pros and cons of using single options to create risk reversals…**

When institutions sell options, they have much less margin requirements than you as a retail trader.

An example of a disadvantage of selling a single put is: If you sell a 195 put and the price of the underlying goes below 195, you will start to lose money on the put and keep losing as the underlying price goes down. It could theoretically drop to zero. Therefore, your brokerage will margin your account in a big way.

If you selling a single call option and the underlying price moves above the option strike price, you will start to lose money on that call option. You will also create a good amount of margin by selling a naked call option.

An advantage to you when you sell or buy an individual option is it will usually fill more quickly. This can be helpful if you need a hedge or monies to pay for a hedge right away.

**Market Reversals Can Affect Your Long and Short Options…**

Have you ever been worried about your position when there was a big move down? You saw your profits diminishing so you bought a put option to protect your positon? Most times I’ll bet you paid a big price to purchase the put on the down day.

When the market moves quickly to the downside, volatility tends to go up. This makes the price to purchase a put rise in cost.

After the market moves down, many times the market will reverse quickly to the upside and the volatility drops. This causes the value of the put you purchased when the volatility was high to go down dramatically. Now your position is not looking so good and possibly losing money. All because you did what you thought was the right thing to do by buying a put.

What a bummer; you protected your trade and you end up losing a lot of the value in the put the very next day. Sometimes the market reverses as soon as you purchase the put, which can be even more frustrating.

If the market reverses quickly and you sold an option to help to pay for the option you bought, it also starts to lose money.

**Risk Reversals Using Option Spreads as a Hedge…**

As you know, single call and put options can be expensive for you. Single options can cause large margin requirements. As an alternative, you can create a risk reversal using call and put option spreads to reduce your margin and risk.

If you have a long position and would like protection, you could a buy put option spread and sell a call option spread on the same underlying. This can help to hedge your position if the price of the underlying position moves in the wrong direction.

One of the advantages of a risk reversal composed of option spreads is if the market reverses, the option spread will tend to lose less than using single put or call options.

The risk in an option spread is determined by the width of the spread. If your option spread is structured buying one 210 strike call and selling one 215 call option and the price of the underlying moved beyond 210, your risk on the spread would be limited to $500.00 plus commissions. This is calculated by taking the distance between 210 strike call option 215 call option which equals 5 points (5 points times 100 contracts) or $500.00 plus commissions.

**Here’s an example of a Risk Reversal using Option Spreads**

** **

**Figure C. Long 100 Shares AAPL with a Risk Reversal using Spreads**

In Figure C 100 shares of long stock is shown by the red line. This risk reversal has been constructed using option spreads. The call spread is short 1 210 call option and long 1 215 call option for a credit of 1.55. The put spread is long 1 195 put option and short 1 190 put option for a net debit of 1.45. This risk reversal is entered for a net credit of .10 (1.55 credit minus 1.45 debit) less commissions.

Look to the left side of the risk graph. The blue line has a small flat area which shows the protection from the long put spread. The option spread offers some protection, but not as much as the single long put which is shown in Figure B.

The margin to enter this position is $20,257.00.

**The Directional Option Risk Reversal Position…. **

Stock or an underlying position is not required to create a risk reversal. A directional risk reversal can be created using just put and call options.

The risk reversal can also be used as a bullish or bearish directional trade. If you are correct in your directional assumption, you will profit.

If you are bearish you can enter a bearish risk reversal position. You would buy a put spread and sell a call spread.

If you are bullish you can enter a bullish risk reversal position. To do this you would sell a put spread and buy a call spread.

The goal with a directional risk reversal is to make a profit then take some of the profits off the table. You can then play with the house money to hopefully gain even more profit.

**Here’s a risk graph of a bullish risk reversal using option spreads…**

** **

** **

**Figure D. AAPL Risk Reversal using only Option Spreads**

Figure D is showing a bullish risk reversal with option spreads. The AAPL call spread is long 1 210 call option and short 1 215 call option for a debit of 1.60. The put spread is short 1 195 put and long 190 put for a debit of 1.40. The cost to enter this risk reversal is .20 plus commissions. The margin is the width of the spread which is $500.00

**Adjustments can be made to a Risk Reversal…**

Risk reversals are very flexible when it comes to adjustments to match your market opinion.

A position can start out as a risk reversal and then be adjusted to accommodate the position as the underlying price movement changes. One adjustment strategy is to take one side of the risk reversal and turn it into a broken wing butterfly.

If the market does not cooperate with your directional bias the position could be adjusted to hedge off some of the upside risk.

**What’s a good time to take off your risk reversal?**

If your market opinion changes it can be a good time to take off your risk reversal. If you have made an adjustment, you probably have hedged off your risk, so it could be a good idea to take off your risk reversal.

For a good discussion about risk reversals and advanced risk reversals offered by Aeromir, go to this Round Table with Scott Ruble on Risk Reversals.

**In Summary…**

Risk Reversals have advantages; some of those are:

- Low cost to enter the position
- Risks can be low
- Profit can be good
- Fits a variety of trading methods
- Numerous methods to adjust
- Can be implemented with or without stock
- Can offer portfolio protection

Risk Reversals have disadvantages; some of those are:

- Required margin can be high
- Large risk for the short leg

Good Trading!

P.S.

Please feel free to leave a comment below. Tell us and share your likes and dislikes about the risk reversal strategy.

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The broken wing butterfly (BWB) is an advanced strategy involving the use of multiple options. The butterfly strategy is generally thought of as a neutral to slightly directional strategy, which will often benefit when the market does not move too much in price.

A Broken Wing Butterfly has long strikes which are not the same distance from the short strike. One of the wings has greater width from the short strike. This results in one side of the position having more risk than the other side, which makes the broken wing butterfly slightly more direction than a traditional butterfly. The wing which has more distance from the short strike is called the “broken side”, thus the name broken wing butterfly.

There are many advanced traders who construct the broken wing butterfly in various ways to adapt to numerous market conditions. They will enter a trade, and then make adjustments to the position as market conditions change.

For the purpose of today’s discussion, we will be focusing on a basic broken wing butterfly.

**First let’s take a brief look at a Traditional Butterfly…**

The traditional butterfly can be constructed using call or put options.

**The Traditional Call butterfly is constructed using each long option the same distance from the short strike. The distance from each long option strike to the short option strike is called a wing.**

- Buy one call option above the short strike
- Sell two call options
- Buy one call option below the short strike

**Here is an example of Traditional Call Butterfly with 20 point wing widths.**

**Figure A: SPX Traditional Call butterfly with 20 point wing widths**

The price of SPX in this example is 2668.73. This traditional call butterfly has a 2665 lower long strike which is slightly In-the-Money. The two short strikes are at 2685. The upper long strike is placed at 2705. As you can see, both long calls are 20 points away from the short calls. The maximum loss on the trade at expiration to the downside, or left of the risk graph, is ($165.00), as shown by the 2640.00 price slice. The maximum risk, or loss, to the upside at expiration is ($165.00), as shown by the 2730 price slice. The maximum profit is $1835.00, which is at the 2685 short strikes, as shown by the 2685 price slice.

**The Traditional Put Butterfly is constructed using each long option the same distance from the short strike. **

- Buy one put option above the short strike
- Sell two put options
- Buy one put option below the short strike

**Here is an example of Traditional Put Butterfly with 20 point wing width.**

** Figure B: SPX Traditional Put Butterfly with 20 point wing widths**

The price of SPX is 2668.73 in the example being used. This traditional put butterfly has a 2630 lower long strike which is Out-of-the-Money. The two short strikes are at 2650. The upper long strike is placed at 2670, which is slightly In-the-Money. As you can see, both long puts are 20 points from the short puts. The maximum loss on the trade at expiration to the downside, or left of the risk graph, is ($135.00). This is the debit to enter the trade, as shown by the 2620.00 price slice. The maximum risk, or loss, to the upside at expiration is the debit to enter the trade ($135.00), as shown by the 2680 price slice. The maximum profit is $1865.00, which is at the 2650 short strikes, as shown by the 2650 price slice.

**How is the Broken Wing Call Butterfly Constructed?**

**The Broken Wing Call Butterfly is constructed using each long option with different distances from the short strike. **

There are numerous wing widths which can be used to construct a broken wing butterfly. Let’s explore an example of how a broken wing butterfly could be constructed with call options having 20 and 30 point wing widths.

- Strike A: Buy one call option 20 points below the short strike
- Strike B: Sell two call options
- Strike C: Buy one call option 30 points above the short strike

The scenario we are discussing here assumes you are mildly bullish and thinks the price of the underlying asset will move up in price gradually. Strike A is purchased at, near, or slightly In-the Money in relation to the underlying price of the asset. This means you would want the price of underlying asset to move up towards the short strike. Option strike B and option strike C are Out -of- the Money when the trade is first entered.

The trader’s goal is to profit from the price of the underlying moving up in a gradual manner. The trader is not looking for a large, fast move in the price of the underlying. The trader is looking for both call option strikes B and C to decay in value towards zero. This would potentially allow the trader to realize a profit from Strike A.

**Here’s an example of a Call Broken Wing Butterfly with 20 and 30 point wings… **

**Figure C: SPX Call Broken Wing Butterfly with a 20 point wing and a 30 point wing**

This broken wing call butterfly has a 2665 lower long strike, which is slightly In-the-Money with a 20 point wing. The two short strikes are at 2685. The upper long strike is placed at 2715, creating a 30 point wing. There is no risk to the downside on this trade, as shown by the 2640 price slice. The position at expiration to the downside, or left of the risk graph, is a positive $275.00. This is the credit received when the trade was entered. The maximum risk, or loss, to the upside at expiration is a loss of ($725.00), as shown by the 2730 price slice. The maximum profit is $2275.00 which is at the 2685 short strikes, as shown by the 2685 price slice. There is greater risk and a greater profit potential with the broken wing call butterfly, as compared to the traditional call butterfly.

**The Peak of the Broken Wing Butterfly**

When you look at the risk graph of a broken wing butterfly, you will notice a peak. With a somewhat bullish call option position, a trader will make money as the price of the underlying moves in the direction of the peak of the risk graph. The trader makes money in this call BWB when option strike B and C decay in value and option strike A retains or gains value. The trader’s goal is for the price of the underlying asset to not go past the two B option short strikes.

With a mildly bullish call BWB position, the price of the underlying is many times at or near option strike A. Remember, strike A is a long call option position, because the trader purchased the option.

At option strike B, the trader is short two calls. Those two short calls represent the peak of the risk graph. The two short calls are sold by the trader. The trader is selling two call options.

The center point, or peak of the risk graph, is where the maximum profit would potentially occur. For the most part, gaining the maximum profit at the peak of the risk graph at expiration will rarely happen. But, when the price of the underlying is inside the triangle of the risk graph, there is potential profit which could be realized. This is a large area for potential profit, which could tend to increase the probability of a profitable trade.

**Broken Wing Butterfly using Put Options…**

**Now let’s look at an example of a broken wing butterfly using put options with 30 and 20 point wings. **

- Strike A: Buy one put option 30 points below the short strike
- Strike B: Sell two put options
- Strike C: Buy one put option 20 points above the short strike

The trader is mildly bearish on the underlying asset. The trader’s goal is for the underlying price to move down from option strike C towards the center option strike B.

The trader’s goal is to allow option strike A and option strike B to decay towards zero which would allow a profit on option strike C.

**Here’s an example of a SPX Put Broken Wing Butterfly with 30 and 20 point wings… **

**Figure D: SPX Put Broken Wing Butterfly with a 30 point wing and a 20 point wing**

This broken wing put butterfly has a upper long strike at 2670, which is slightly In-the-Money with a 20 point wing. The two short strikes are at 2650. The lower long strike is placed at 2620 creating a 30 point wing. There is no risk to the upside for this trade, as shown by the 2680 price slice. The position at expiration to the upside, or right of the risk graph, is a positive $455.00. This is the credit received when the trade was entered. The maximum risk, or loss, to the downside at expiration is a loss of ($545.00), as shown by the 2620 price slice. The maximum profit is $2455.00 which is at the 2650 short strikes, as shown by the 2650 price slice. There is a greater risk and a greater profit potential with the broken wing put butterfly, as compared to the traditional put butterfly.

**Wrapping it up….**

The broken wing butterfly has more profit potential, but also has more risk as compared to a traditional butterfly.

Learning this strategy can take some time for someone who is new to options trading. It is important to learn this broken wing butterfly using a simulator or paper account. This allows you learn how the strategy reacts to a variety of market conditions. The volatility and price of the underlying asset can change quickly, which can affect the profit and loss of a broken wing butterfly.

There are numerous methods to construct and then manage a broken wing butterfly. As always, it is your responsibility as a trader to learn a method which is within your risk tolerance. It is easy to say” I can handle it” and be comfortable with a particular possible loss when you are in a paper account. When you switch over to using real money and you have a loss, it can be a different story.

It often becomes hard for a trader to accept a loss emotionally. This can lead to poor risk management. The trader may not take the loss and stay in a particular position hoping the profit and or loss will improve. Sometimes this works, but other times it does not work. It can be better to take the loss so the account does not take a big loss.

There are many experienced traders in the Aeromir Community who trade the broken wing butterfly. Please feel free to leave a comment below.

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A calendar spread is a strategy often referred to as a time spread. A calendar is a method which could benefit from the time decay of an option and changes in implied volatility.

For the most part a calendar concentrates on the movement of time and volatility more than the movement of the underlying asset. For this reason a calendar spread can be used for either stagnant or large movements in the underlying.

Like any strategy the calendar has advantages as well as disadvantages. The risk can be quite limited for the buyer; the seller can have a larger risk. To contain some of the risk, a seller can act on the position at the expiration of the near term option. There are also strategies which can be used to lessen the seller’s risk.

One of the advantages of the calendar strategy is the position can be entered with less of an investment than purchasing the underlying asset.

**How is a Calendar Spread created?**

A Calendar spread is constructed by purchasing one option and the sale of another option in different expiration cycles in a one to one ratio. Both options will have the same strike price. The calendar can be created by using either two puts or two calls. The longer out in time option has more time value and will cost more than the closer in time option.

**How to construct a long Calendar…**

If you think the volatility is at a low level, you can buy a long calendar. To create a long calendar, you would purchase one option with an expiration further out in time and sell one option with expiration closer in time. As an example, you would buy a February 50 Call option and Sell a January 50 Call option. Another example, would be to buy February 50 Put option and sell a January 50 put option.

Figure A. Long Calendar Risk Graph from Think or Swim

As you can see in Figure A, the strike price of 50 is at the center of the risk graph. The highest profit potential is at the strike price.

**How you could profit from the long calendar spread…**

You can profit from a long calendar spread as time progresses and the price of the underlying stays favorable. The shorter term expiration will decay at a faster rate than the longer term position.

If the volatility increases the further out in time option will increase faster than the closer in time option. This will tend to increase the value of the calendar spread.

If you enter the calendar spread either in-the-money or out-of-the money and the price of the underlying moves towards the strike price, the position will gain in value.

**How you could lose from a long calendar spread… **

A decrease in implied volatility will decrease with the farther out in time option more quickly than it will decrease the value of the closer in time option. This will cause the position to lose value.

If the price of the underlying asset moves away from the calendar spread strike price, the calendar spread will decrease in value.

**How to construct a short Calendar Spread…**

If you have the assumption volatility is at high levels, you can create a short calendar. To create a short calendar, you would sell the farther out in time option and buy the nearer term option. For instance you would sell a February 50 Call option and buy a January 50 Call option.

Figure B. Short Calendar Risk Graph from Think or Swim

As shown in Figure B, the short calendar profits more as the underlying moves away from the center strike of 50.

*A word of caution concerning short calendar spreads. Shorting the longer dated option and buying the shorter dated option can be risky. The shorter dated option will expire before the longer dated option. This could lead to the seller of the longer dated option being naked that longer dated option. Therefore, the brokerage will most probably margin your account as though you are short the naked option. *

**How you could profit from a short calendar spread …**

If implied volatility decreases, the further out in time option which was sold will tend to lose money more quickly than the closer in time option which was bought. This is due to the higher Vega in the further out in time option. This will tend to create an increase in value to the seller of the calendar spread.

If the underlying asset moves up or down, away from the strike price of the calendar spread which was sold in either direction, it will tend to increase in value for the seller of the calendar spread, as long as the time decay of the option does not outdo the movement of the price of the underlying.

**How you could lose from a short calendar spread …**

As time passes it will usually negatively affect the seller of a calendar spread. This is due to the nearer term option, which is the long option for the seller, decaying at a more rapid pace than the farther out in time option, which the seller of the calendar spread is short.

If implied volatility increases it will also affect the seller of the calendar spread negatively. When the volatility increases the longer term option which was sold increases in value more quickly than nearer term option which the seller is long due to the longer term options higher vega.

**At-the-Money vs. Out-of-the-money and In-the-money options… **

Many times calendar spreads are entered at-the-money due to at-the-money options having the greatest amount of extrinsic value. The extrinsic value of an option will decay as the option gets closer and closer to expiration. This can be beneficial for a calendar spread because the strategy is looking for time decay.

There are other calendar strategies which can be constructed using out-of-the-money and in-the-money options. It is your choice.

The decay rate of the option with the same strike price, which has a longer expiration date will be slower to erode than the decay rate of the option which is closer to expiration. This applies to an in-the-money option, out-of-the money option or at-the-money option.

**Gamma’s Effect on the Calendar Spread…**

Gamma can be defined as the rate of change of the option’s delta as it relates to the movement in the price of the underlying. It can be thought of as the delta of the delta.

Gamma tends to be highest with at-the-money options in the nearer term expiration. Gamma will tend to decrease the further the price of the underlying moves away from the at-the-money strike and as the expiration date moves further out in time.

The nearer term option expiration will move more quickly due to its’ gamma being higher.

**How Does Volatility Influence a Calendar Spread?**

It is important to monitor the change in volatility when using the calendar spread strategy.

The volatility of an option is measured by vega. Vega is an approximate measurement of how much an options price will tend to change with a one point move in implied volatility.

Vega is shown in dollars for a one tick move or change in volatility. Let's say an option is valued at $2.00 and has 45 implied volatility with a vega of .05. Then the volatility moves up one tick to 46. The option would now have an approximate value of $2.10.

This is calculated by multiplying .05 times 2.00 which equals .10 or 10 cents. Adding the .10 to the original value of the option which was $2.00 equals $2.10.

**Key points about vega …**

- The price of an option will change as volatility increases or decreases
**Vega will tend to decrease with shorter dated expiration options**- Vega will tend to increase with longer dated expiration options
**Vega tends to be greatest with at-the-money options**- Vega applies to the strike price both calls and puts
**Vega will tend to increase when volatility increases**- Vega will tend to decrease as volatility decreases

**Wrapping up the Calendar Spread…. **

- Use two call options or two put options
**Use the identical strike price for both of the options**- Select different expiration periods for each option
**Create a one-to-one ratio**- Any two expiration periods can be used to create the calendar spread.

Usually, the calendar spread benefits when the price of the underlying is not moving too much and stays within a range.

If you have limited capital, the long calendar spread offers limited risk when entered as a debit. The risk is defined to the debit paid for the calendar.

You can use the calendar spread when volatility changes are expected.

As a seller of a calendar spread, you can take on potentially greater risk.

When the underlying price moves away from the calendar strike price, the buyer of a calendar will tend to lose money.

When the underlying price moves away from the calendar strike price, the seller of a calendar could increase profits as long as time decay does not surpass the movement of the underlying’s price.

If you have experience trading calendars, either long or short, and would like to share with the community, feel free to comment below.

Are you new to trading looking for mentoring, or an educational trade alert service? Or, are you a veteran seeking a trading group where you can interact with like-minded traders who share their experiences? Look no more. Join Aeromir today!

]]>On July 21, 2018, an introductory article was published about trading the foreign exchange market (Forex, or FX). That article can be found here: Introduction to Forex

Today we will continue this educational series with a bit of information to help those unfamiliar with the Forex market understand how the pricing works, as well as touch on the difference between currency futures and Spot Forex.

**How does the pricing work in the Forex market?
**

Currency trading is performed in pairs. The currency pair is composed of a base currency and a quoted currency. The quoted currency is sometimes mentioned as the “counter currency”. Many times the base currencies which are traded are the EUR (Euros), the USD (US Dollars), the GBP (British Pounds),and the AUD (Australian Dollar).

An example of a currency quote is as follows:

**EUR/USD 1.1600**

The EUR is the base currency and the USD is the quoted currency or counter currency. When looking at this quote, the Euro has a value or worth of 1.16 US Dollars.

Any currency can be the base currency. It could be the EUR, the USD, the GBP, or any of the other currencies. The base currency is always equal to 1. The quoted value of 1.1600 indicates it would take 1.1600 USD (US Dollars) to equal 1 EUR (Euro).

Most currencies extend out to 4 decimal points. A pip is the smallest measurement of a forex trade. The term “Pip” is the abbreviation for point in percentage.

Using the USD as the base currency, the quote would look like this:

**USD/EUR .8621**

This indicates 1 USD is equal to .8621 EUR. When you divide 1 by .8621 you get approximately 1.16. Do you see how the two quotes have the same relationship in value?

**A little bit about Ask and Bid Prices….**

Forex pricing is similar to most financial markets. When you trade a currency pair, there is a bid price and an ask price. The bid and ask prices are in relation to the base currency. The bid price is the price at which a trader is able to sell a currency pair. The Ask price, also referred to as the “Offer”, is the price at which a trader is able to buy a currency pair.

Below is an example of a price quote on the USD/EUR currency pair showing the bid and ask prices:

**EUR/USD = 1.1600/05**

**Bid = 1.1600**

**Ask = 1.1605**

In this example, the bid is 1.1600 and the ask is 1.1605. Usually, the difference between the bid and ask is a small fraction … less than 1/100th of a unit of the currency. Therefore, many times the last two digits after the slash in the price quote for the bid and ask are shown. For instance, the EUR/USD 1.1600/05.

Showing the bid and ask a different way would look like this:

**EUR/USD = 1.1600/1.1605 (1.1600 is the bid 1.1605 is the ask)
**

The mathematical difference between the Bid price and the Ask price is called the spread. Using the EUR/USD price quote of 1.1600/05, the spread would be .0005 or 5 “pips”. When referring to the Euro, U.S. Dollar, British Pound, or Swiss Franc, one pip would be equal to .0001. Because the Japanese Yen is quoted to two decimal places, one pip would be .01.

While changes in the spread may seem to be negligible to some, even the smallest change in pips can result in thousands of dollars being lost, or made, due to leverage. Those unfamiliar with leverage may want to refer to the original introductory Forex article (link provided above) for details on the impact leverage can have on those trading the Forex. Leverage is also one of the main reasons that many find trading the Forex so attractive.

The majority of currencies trade within a range of 100 to 200 pips each day.

**What influences prices in the Forex market?
**

Forex markets and the prices of currencies are mainly influenced by the flow of international trade and investment. It is also influenced by, but to a lesser degree, many of the same factors that affect pricing in the equity and bond markets. These may include political stability (or instability), economic conditions, interest, and inflation. These factors may have a longer term effect for traders of equities and bonds. Quite often it is the immediate reaction to such occurrences that causes volatility this is another reason that many day traders find trading the Forex market so appealing.

**How do Currency Futures and Spot Forex compare?
**

Traders have a choice of trading currency futures, as well as the spot Forex market. The difference between the two is not significant, but it’s worth being aware of them.

A currency futures contract is a contract that is legally binding, and obligates the buyer and seller to trade a particular amount of a currency at a specified price. This price is the published exchange rate. The transaction would occur at some point in the future, which is the settlement date.

The spot market in forex is the place where currencies are bought and sold at the current price. With the spot forex rate, the underlying currencies are physically exchanged following the settlement date. Generally speaking, the spot market involves the actual exchange of the underlying asset. Have you ever gone to a bank to exchange one currency for another? If you have, you have taken part in the forex spot market.

One of the main distinctions between currency futures and spot Forex is when the trading price is determined, as well as when the physical exchange of the currency occurs. With currency futures, the price is set on the signing of the contract and the currency pair is exchanged on the delivery date which is some point in the future.

With spot Forex, the price is also determined at the point the trade is made, but the physical exchange of the currency pair takes place at the same point the trade is made, or within a short amount of time thereafter.

Currency futures are based on the currency spot rate. Because of this, currency futures prices tend to change as the spot rates change.

If the spot rate of a currency pair increases, the futures price of a currency will likely increase. Also, if the spot rate of a currency pair goes down, the futures price has a good probability of decreasing. However, this is not always the case. Sometimes the spot rate will change, but futures with a longer-term expiration may not. Why? The spot rate move may be viewed as short term, and unlikely to affect long-term prices.

Most traders in the currency futures market are speculators and usually will close their positions before the settlement date.

**To summarize Forex pricing:
**

• The first currency listed in a quote is the base currency

• The Bid price is used when selling currencies

• The Ask price is used when buying currencies

• The difference between the Bid and Ask prices is called the spread

• The spread is called a pip, or point

• The pricing on both currency futures and the spot Forex market is determined at the point the trade is entered, but delivery date of the currency pair differs.

In a future article we will talk in a bit more detail about understanding the risks of trading the foreign currency market.

If you have anything you would like to share regarding Forex pricing or currency futures versus spot Forex, feel free to comment below.

Are you new to trading looking for mentoring, or an educational alert service? Or are you a veteran seeking a trading group where you can interact with like-minded traders who share their experiences? Look no more. Join Aeromir today!

Diversifying your portfolio can help reduce some of the risks in trading, as well as help to maximize your returns. Most professional investment advisors will agree that while diversification certainly does not provide any guarantee to prevent losses, it can be a very important element in reaching longer-range income goals while minimizing risk. Most are familiar with the phrase “don’t put all your eggs in one basket”. The same goes for your trading portfolio.

**There are two different types of risks for traders …**

- Undiversifiable risk. This is also referred to as “market risk”, and is relevant to all markets. Such occurrences as political instability, interest rates, exchange rates, inflation rates, and unknown events (war) … are all undiversifiable risk. This type of risk is not associated with any particular sector or industry, and cannot be eliminated through diversification. Undiversifiable risk is a risk every trader must accept.
- Diversifiable risk. This is also referred to as “unsystematic risk”, and can be specific to a particular industry, market, economy, or country. This type of risk can be reduced through diversification, which is the focus of today's article.

When you diversify your portfolio … by trading different time frames, multiple markets, various strategies, and a variety of underlyings, you can generate more potential sources for profits. Diversifying by industry is also helpful, such as previous metals (gold, silver), airlines, pharmacies, construction, real estate, overseas markets, etc. All of this this helps protect you when the market shifts and puts any one particular strategy or underlying at a disadvantage.

**What are some methods for diversification?**

For those who are option traders, there are some diversification strategies they may want to consider. Multiple asset classes such as volatility instruments, bonds, stocks, ETF’s which follow the market, and ETF’s which follow the commodities markets can play an important role in protecting one's portfolio. When and if one market moves in a particular direction, the other asset invested in a different asset class may not be affected in a negative manner. Generally, the bond and equity markets move in opposite directions.

Using different types of strategies can be a good method to diversify. For instance, you may want to have directional long and short positions in play on different underlyings at the same time. These can be created as debit spreads, credit spreads, long or short calls and puts. Another good idea is to have some market neutral strategies such as iron condors and or butterflies.

**Using different entry and exit times can help diversify …**

When a trader buys or sells stock, there is not an expiration date. As long as the company stays in business there is value in the stock.

On the other hand, options have an expiration date which can allow a layer of diversity. This can be accomplished by having multiple positions in play, with short and long term expiration dates. If the positions are entered with different entry and exit expiration dates, it creates a layering effect. If the positions you are trading do not expire at the same time, it may help to reduce risk when there is volatility in the market. Another good quality of layering is all the positions do not expire at the same time which can give you more flexibility.

If the market is moving quickly, the longer term positions may need less attention than the shorter term positions. This can give you the much needed time to react to those positions which need an adjustment or exit.

**Cash is a position …**

It also makes sense in any trading portfolio to maintain a portion in cash. I am a firm believer of the phrase “cash is a position”. There are times that balance between capital allocated to the market, and cash may shift. Such times are in an extremely volatile market condition where it simply too dangerous to trade any market or asset class. The amount of capital you choose to set aside as cash also depends on whether you are a conservative or aggressive trader, as well as your risk tolerance.

**Here are some key points for you as a trader to consider when diversifying your trading business …**

However you choose to diversify your portfolio, it is important to remain within your range of experience. It will not help your success as a trader to begin trading any market, asset class, or strategy that has not been thoroughly tested. Remember, diversification only makes sense when you feel it can add unique value to what you are already trading.

It is also important not to over-diversify. This can be related to the popular belief that “more is better”. This is not always the case in trading. If the overall market begins to move quickly and there are too many positions in play, it can lead to difficulty managing the trades. Fear and stress can cause a trader to make poor decisions. Fear can even cause a trader to freeze up and be unable to trade. Over-diversification can result in lower-expected results, and a possible failure to reach your annual income goals.

**In summary …**

For any business to be successful over time, they must always be innovative, and add sources of revenue to take advantage of changing markets and types of customers. The same principals need to be applied for a trading business to remain successful. Trends change, markets change, and the level of volatility and risk change. Therefore, it is important for a trader to keep abreast of these changes and develop a trade plan which adapts to the market changes.

Think about diversification this way: it is like living a balanced life, where you get the proper mix of things such as exercise, nutrition, work, play, laughter, travel, quiet time, giving, friends and family time. When you diversify your life and have the proper mix of all of these elements, you're more apt to have a happier life.

Of course, creating a balanced life does not provide any guarantees that it will lead to a longer life; but it can help. The same goes with diversification in trading – there are no guarantees that by diversifying your portfolio you will not incur any losses, but diversifying can, at the very least, spread that risk over a variety of sources. When you diversify your trading business, you are more likely to experience better results over time.

However you choose to diversify your trading business, do your due diligence so that you are comfortable your trade plan has enough potential income sources to weather storms that you may encounter along the way. There is no specific model or guideline for diversification that will meet the needs of every trader. Choose your method so it aligns with your own tolerance to risk, and overall income goals. If, when researching methods to diversify your portfolio appear overwhelming with too many choices, consider consulting with a fellow trader or financial advisor who may help you in your decision-making.

If you have a specific mix of diversification that has helped you balance your portfolio and would like to share, feel free to comment below.

Are you looking for a trading group to share trade ideas and perhaps methods of diversification? Look no more! Aeromir offers a variety of trading groups, mentoring and educational trade alert services for all levels of experience. Join today!

]]>Gamma, one of the options “Greeks”, is often referred to as the Delta of the Delta. Gamma is the rate of change in the delta of an option per a one-point move in the underlying instrument. It is important for traders to understand the effect Gamma can have on their positions. As Gamma increases, it can dramatically affect a position in terms of its profitability.

To define and provide an understanding of Gamma, we will first touch on Delta. Delta measures the price movement of an option with a $1.00 movement in the underlying. If an option has a .38 Delta and the underlying instrument moves $1.00, the option price theoretically would move $.38 in value. Thus, the new option price would theoretically be $1.38.

**What is long Gamma?
**

When you purchase an option, either a call or put, it creates long Gamma. If you are long Gamma and the underlying instrument increases in value, the Delta of the option strike will theoretically increase by the amount of your Gamma for every $1.00 move in the underlying instrument. If the underlying's price decreases, the Delta of the option strike would theoretically decrease by the amount of the Gamma for every $1.00 movement in the underlying. So, if the underlying's price increases and you are long Gamma, your Delta would theoretically increase. The opposite occurs if the underlying price decreases and you are long Gamma – your Delta would theoretically decrease.

**What is short Gamma?**

When an option is sold, you are short Gamma. When a position is short Gamma and the price of the underlying increases, the position Delta would decrease. Conversely, if a position is short Gamma and the price of the underlying decreases, the Delta of the position would increase.

**How Gamma and time are related…**

Time affects Gamma.

The closer an option gets to its expiration, the higher the Gamma. An option's Gamma is highest in the nearest term expiration cycles. Gamma is also highest for options at-the-money or near-the-money. As with many aspects of trading, there are exceptions to this which I'll discuss later on. Gamma tends to decrease as the underlying's price moves away from the at-the-money strike. As the price moves further in-the-money or further out-of-the-money, the Gamma tends to decrease.

Let's use Figures A and B below with SPY as an example to illustrate the affect time has on Gamma. Below are two option chains for SPY; 7 September which is 2 days until expiration, and 19 October which is 44 days until expiration.

SPY is currently trading at 289.64, so the 290.00 strike is at-the-money for the October 19 cycle, and the 289.50 strike is at-the-money for the 7 September cycle.

Figure A. SPY Put Option Chain 44 Days to Expiration, SPY currently trading at 289.64.

Figure B. SPY Put Option Chain 2 Days to Expiration, SPY currently trading at 289.64.

Refer to the Gamma column in Figures A and B to see how Gamma is affected by time. Also notice the relationship of Gamma at-the-money, and further out-of-the-money. Do you see how it tends to be higher at-the-money? Do you see how Gamma tends to decrease as it moves away from the at-the-money strikes?

**As I said earlier, there are exceptions to the effect of Gamma over time …
**

What are the exceptions? At times, the back period expirations can have higher Gamma than the near-term expirations. This may occur because options that are very deep-in-the-money act like the stock itself, and stock itself has no Gamma.

**It's important to understand how Gamma can affect a position which is composed of multiple options…
**

As shown in the SPY option chains in Figures A and B above, each option strike has it's own Gamma. Most trading platforms combine the Gamma for each option, and calculate the long and short Gamma to determine the overall Gamma of a position composed of multiple options.

Many traders manage their positions according to Gamma, and feel that Gamma can be a measure of how often a position may need adjusting. They do this by looking at the T + 0 line (the black, curved line in Figures C and D below) You can get a visual of Gamma on most platforms when you view a risk graph. Is the T + 0 line relatively flat or is it curved? If your T + 0 line is flat or only slightly curved, your position will have less Gamma. If it is steeply curved, your position will have higher Gamma.

Using SPY again, see the two Iron Butterfly positions in Figure C and D. We will use the same expiration cycles as in the option chain example above … September 7, which is 2 days to expiration, and 19 October which is 44 days to expiration.

Figure C. SPY Iron Butterfly 2 Days to Expiration (sharply curved T + 0 line)

Figure D. SPY Iron Butterfly 44 Days to Expiration (flatter T + 0 line)

The two positions shown above in Figure C and D are for an at-the-money Iron Butterfly, which consist of: Short the 290 call strike, long the 295 call strike; short the 290 put strike, and long the 285 put strike.

In Figure C, with only 2 days until expiration, the Gamma is -27.42, whereas the position Gamma in Figure D which has 44 days until expiration is only -.1.10. See how steep the curve is on the T + 0 line (black, curved line) in Figure C versus Figure D?

Those who trade shorter term positions such as weeklys take on the potential of a higher profit, as well as the risk of a larger loss on their positions with even the smallest move in the underlying. This is mainly because of Gamma. More conservative traders who trade longer-term positions such as the one in Figure D have less potential risk of a major profit or loss, at least early in the trade, due to the lower Gamma.

**Summing it up…**

It can be confusing at times, particularly for those traders with less experience, to remember the characteristics and relationships of an option's Gamma and Delta. An easy way to remember them is:

• Positive Gamma makes Delta more and more positive as the underlying price increases.

• Negative Gamma makes Delta more and more negative as the underlying price increases.

Gamma, like the other option Greeks – Delta, Theta, Vega, and Rho, is a metric that can be used to measure the level of risk for a position or portfolio. While Delta is often used as the Greek that affects a position's profit and loss as the underlying price moves, Gamma is a metric that a trader can use to gauge how much the Delta may move.

If you have any additional insights to Gamma and how you use it to manage your positions and would like to share, feel free to comment below.

Whether you are new to trading, or an experienced trader looking to fine-tune your craft, the Aeromir community is here to help you. There are trading groups where you can share your trades, educational trade alert services, mentoring, and more. Don't hesitate, join today!

]]>Because trends are composed of a series of price swings, momentum can play a key role in determining the strength of the trend. It is important to know when a trend may be slowing down, as it may be indicative of a reversal. How can a trader assess the strength of a trend? Using momentum, along with rate of change and momentum divergence, can signal something may be changing. This could mean that the trend may consolidate, or even reverse.

Price movement refers to the direction and magnitude of price. By comparing price swings, a trader may gain insight into price momentum.

**How is momentum defined?**

The magnitude of price movement is measured by the length of the short-term price swings. The beginning and end of each swing is established by price pivot points, which form swing highs and swing lows. Strong momentum is indicated by a steep slope and long price swing. Conversely, weak momentum is exhibited by a shallow slope and short price swing.

There are several momentum indicators such as the Relative Strength Index (RSI), Stochastics, and Rate of Change (ROC). The examples we will be using are analyzed with the Rate of Change Indicator.

Below is a six month chart of SPX with the Rate of Change Indicator.

Figure A. SPX 6 month chart with Rate of Change Indicator

As you can see in Figure A, for each upswing in price, there is a similar upswing in the Rate of Change (ROC). When price swings down, ROC also tends to swing down.

**What is the calculation for Rate of Change?
**

The default settings for Rate of Change calculation on Think or Swim as shown in Figure A above are:

• Length – the number of bars used to calculate the Rate of Change. Think or Swim uses 14-days as the default.

• Color norm length – the number of bars used to calculate the color gradient. In Figure A above, this is also 14-days. You can see the gradual change from red to blue as the price changes.

• Price – This is the price used in the calculation of Rate of Change

In Figure A above, the default setting on Think or Swim is the closing price. Traders have a choice of other prices such as open, high/low divided by 2, high/low divided by 3, volume, etc.

In the case of Figure A above with the default settings as outlined, the rate of change divides today's closing price by the closing price days 14 days prior. If both values are equal, ROC is 1. If today's price is higher, then ROC is greater than 1. Conversely, if today's price is lower, then ROC is less than 1.

Many traders find oscillators such as ROC are most useful using narrow time frames, detecting potential short-term changes in the market, perhaps within the time frame of a week. Other indicators that are trend-following are most often better used for longer-term trends.

**What Rate of Change means for traders …
**

In general, when ROC is rising, it indicates a bullish market and prices are likely to continue higher. When ROC is falling, the outlook becomes bearish and lower prices could be likely.

When prices rise but momentum or ROC falls, this is called momentum divergence, which we will discuss next.

**What is divergence?
**

Divergence is usually associated with an oscillator indicator. For the purpose of this discussion, we will continue to use the Rate of Change indicator. Many traders use divergence to aid in their decisions for new trade entry, adjustments, or exit.

Divergence in technical analysis can occur when the price of an underlying and an indicator are moving in the opposite direction of each other on a price chart.

• Bullish divergence occurs when the underlying price is moving lower as the indicator moves higher.

• Bearish divergence occurs when the underlying price reaches a new high, as the indicator moves lower.

Either bullish or bearish divergence may be a signal of a shift in the direction of the price of the underlying.

You can see an example of both bullish and bearish divergence on the charts below:

Figure B. Bullish Divergence chart from Think or Swim

Figure C. Bearish Divergence chart from Think or Swim

**How can traders interpret divergence?**

Bullish, or positive, divergence can be a signal the downtrend may be weakening. Traders may interpret the lower lows in price while Rate of Change makes higher lows to be an indication a rally is forthcoming. This may be a signal to go long and enter a bullish position.

Bearish, or negative, divergence could be a signal the uptrend may be weakening. Traders may interpret the higher lows in price, while Rate of Change makes lower lows, to be an indication a downtrend may be forthcoming. This may be a signal to go short and enter a bearish position.

**In conclusion …
**

The momentum indicators can be powerful indicators that can guide the trader on not only the market's future direction, but also the speed of the direction. It is important to note that there must be price swings of sufficient strength to make momentum analysis valid. When the market is in a strong trend in either direction, oscillators tend to not function all that well.

Momentum divergence can indicate that something is changing, but it does not mean the trend will always reverse. It is a signal a trader could consider to make modifications to his/her strategy…trade entry, adjustment, and/or exit.

Those using the Rate of Change or other momentum indicators should do so in conjunction with other technical analysis such as price action, support and resistance, volume, etc. Also, any one indicator a trader chooses to incorporate into his/her technical analysis is not going to make you money unless you use it consistently.

If you have found the momentum indicators to be particularly helpful in your technical analysis and would like to share, please comment below.

Whether you are new to trading, or an experienced trader looking to fine-tune your craft, the Aeromir trading community is here to help you. Don't hesitate. Join today!

They have a wide variety of programs including mentoring, educational trade alert services, trading groups, and veteran traders willing to share their trade techniques. When you surround yourself with consistently profitable traders, your own trading can improve.

]]>Intrinsic and extrinsic option values are two components of an option chain which can be very important to an options trader. Knowing the intrinsic and extrinsic option values can help you as an options trader choose a good option candidate with its’ corresponding strike price and expiration. This can be a key factor in laying a foundation for you. This can help to give you an edge in your trading.

If you are new to options trading, please be patient – it takes time to become familiar with the terminology associated with options. It is time well spent for you and your success on becoming a consistently profitable trader.

To start, let’s look at the option chain. An option chain shows all the puts, calls, and the strike prices with each corresponding option price for an underlying asset with its’ expiration date. Below is an option chain of PYPL, showing the current trading price of the underlying, as well as the Bid and Ask prices of each strike price. These are two important components to determine the intrinsic and extrinsic option values of the option.

Most trading platforms allow you to see the intrinsic and extrinsic value of each strike price, so it is not necessary to perform the calculations. However, for those who may be new to trading, I will cover several examples, going through the calculations of the intrinsic and extrinsic value of various strike prices.

Figure A. PYPL 21 SEPT 18 Option Chain

**What is the Intrinsic Option Value?**

To get an understanding of the meaning of the word intrinsic, let’s explore the definition. According to Merriam-Webster, intrinsic is defined as “belonging to the essential nature or constitution of a thing”. According to the Cambridge English Dictionary, intrinsic is defined as “being an extremely important and basic characteristic of a person or thing”.

*The Intrinsic Value of a call 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.*

**Calculating the Intrinsic Value of a Call Option
**

Let’s use the PYPL option chain which is shown above to determine the Intrinsic Value of the 80 Strike Call Option. PYPL’s last trading price was 86.72. Take the last trading price (86.72), and subtract the 80 Strike, which equals 6.72. Therefore, 6.72 is the intrinsic value of 80 Strike Call Option. It also means the 80 Strike Call Option is 6.72 In-The-Money.

Now let’s calculate the intrinsic value of the 90 Strike Call Option. PYPL's last trading price was 86.72. Take the last trading price (86.72) minus the 90 Strike, which results in negative -3.28. Since the result is a negative number, there is zero intrinsic value in the 90 Strike Call Option. It is currently Out-Of-The- Money, therefore, it does not have any intrinsic value.

**Calculating the Intrinsic Value of a Put Option
**

As an example in Figure A, take the 90 strike put option minus the last trading price (86.72) which equals the intrinsic value of 3.28. The 90-strike put option is 3.28 In-The-Money.

Now calculate the intrinsic value of the 80 strike put option. Take 80 minus the last trading price (86.72) which equals a negative -6.72. Since the intrinsic value is a negative number this means the intrinsic value is zero. The option is 6.72 Out-Of-The-Money.

**What is the Extrinsic Option Value?
**

The definition of extrinsic, according to Merriam-Webster, is “not forming part of or belonging to a thing “extraneous”. According to the Oxford Dictionary, extrinsic is defined as ”not part of the essential nature of someone or something; coming or operating from outside”.

Have you heard the saying “time is money”? “Time is money” applies to the extrinsic value an option. If you have a liability, you want to be paid for carrying that liability. Therefore, one of the costs of carrying that liability is the time value or extrinsic value of that option.

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.

An option contract will usually lose value as it approaches its’ expiration date. As a rule, an option that is currently trading Out-Of-The-Money, with 30 days left until expiration, will have more extrinsic value or time value, than an out-of-the-money option with 7 days until expiration. The reason for this is, there is more time left in the 30 days till expiration option than the 7 days to expiration option. Since there is more time remaining in the 30 day option, it has more extrinsic value.

Implied volatility also affects the extrinsic value of an option. Implied volatility is the degree that an underlying asset could move over a certain amount of time based on the current market prices. Implied volatility is only an estimate. If the implied volatility increases, the extrinsic value will rise. If implied volatility goes down, the extrinsic value of the option will also decrease.

In-The-Money-Options can have both Intrinsic and Extrinsic Values. Out-Of-The-Money options only have extrinsic value.

**Calculating the Extrinsic Value of an Option**

To determine the extrinsic value of an option for both the calls and the puts, use this formula:

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

Let’s use the example of the PYPL 80 Strike Call Option which was calculated above to have an intrinsic value of 6.72. To calculate an approximation of the current option price of PYPL 80 Strike Call Option, let’s use the option chain in Figure A. The bid price is 7.50 and the ask price is 7.65, so the average of the two prices is 7.57. This is the approximate option price. Now, take the option price (7.57) minus the intrinsic value (6.72) which equals an extrinsic value of 0.85.

Now let’s calculate the extrinsic value of the 90 Strike Call Option. The bid price of the 90 Strike Call Option is 1.42 and the ask price is 1.46. The average price of the bid/ask is 1.44. The intrinsic value was calculated above to be zero. Now, take the option price 1.44 minus the intrinsic value zero which equals an extrinsic value of 1.44.

PYPL has a current price of 86.72. Therefore, the 90 Strike Call Option is Out-Of-The-Money. The value of the option is made up solely of its’ extrinsic value.

**Calculating the Extrinsic Value of a Put Option
**

Let’s use the example of the PYPL 80 Strike Put Option which was calculated above to have an intrinsic value of zero. To calculate an approximation of the current option price of the PYPL 80 Strike Put Option, let’s continue to use the option chain in Figure A. The bid price is .63 and the ask price is .66. The average of the two prices is .65, which is the approximate option price. Now, take the option price (.65) minus the intrinsic value which is zero, which equals an extrinsic value of .65. PYPL is currently trading at 86.72, so the value of the 80-strike put option is made up entirely of its extrinsic value.

Now let’s calculate the extrinsic value of the 90 Strike Put Option. The bid price of the 90 Strike Put Option is 4.35 and the ask price is 4.60. Therefore, the average price of the bid/ask is about 4.48. The intrinsic value was calculated above to be 3.28. Now, take the option price (4.48) minus the intrinsic value (3.28) which equals an extrinsic value of 1.20.

**Summing it up…
**

Intrinsic and extrinsic option values can help a trader to determine which option or options could help increase the probability of a profitable position. In-The-Money options can have intrinsic and extrinsic value. An In-The-Money option can be exercised. Out-Of-The-Money options only have extrinsic value and cannot be exercised.

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]]>The value of the SKEW Index rises with the tail risk of the S & P 500 Index. When there is no tail risk, SKEW is equal to 100. When SKEW is close to 100, probabilities of a sharp market move remains small. As the probability of a major market move increases, the SKEW index rises.

The mathematical definition of “standard deviation” is a measure of the dispersion of a set of data from its mean. The more the data is spread apart, the higher the deviation.

These standard deviations are important to options traders because they give definitive metrics which can be used to gauge the probability of a successful trade. Of course, there is no indication of the direction of a potential move; you as a trader can use your own technical expertise and chart analysis in conjunction with the standard deviation metrics. It is also worth mentioning that no trade can have a 100% probability of success. Even trades with boundaries of profitability of three standard deviations have the small but real probability of moving outside the predicted range of movement.

Represented by a bell curve, the graph below illustrates standard deviation and a normal distribution curve:

Figure A. Normal Distribution Graph (Image courtesy of Wikipedia.org)

If the data points in the distribution graph are all near the mean (center of the graph), then the standard deviation is close to zero. The farther away the data points are from the mean, the higher the standard deviation. The bell curve in Figure A is a normal distribution, and demonstrates that among a certain number of samples, there is normal outcome. In options trading, these normal outcomes can be used as a tool.

Breaking this outcome into percentages:

• +1/-1 standard deviation covers 68.2% of occurrences

• +2/-2 standard deviation covers 95.4% of occurrences

• +3/-3 standard deviation covers 99.6% of occurrences

Now, compare the normal distribution graph to ones that are skewed (to the left or the right). The chart below illustrates a normal distribution graph, as well as skewed graphs.

Figure B. Distribution Curves (image courtesy of assetinsights.net)

In Figure B, the Positive Skewness (curve on left) has a longer tail to the right, which indicates more tendency of upside risk. The Negative Skewness (curve on right) has a longer tail to the left, which indicates more tendency of downside risk.

**How is the SKEW Index calculated?
**

SKEW is calculated from the prices of S & P 500 options using a similar type of algorithm as that which is used to calculate the VIX, which is the CBOE Volatility Index. The mathematical calculation of SKEW can be found here: SKEW Index calculation

The SKEW Index typically ranges from 100 to 150, with a historical average of approximately 115. The higher the SKEW index rating, the higher the perceived tail risk and chance of a significant move.

Below is a 3 year, weekly chart of the SKEW Index from Think or Swim

Figure C. 3 year weekly SKEW Chart

The 20 period moving average is showing a value of 138.45 in Figure C above. The current SKEW value is 144.49. Since the SKEW's historical average value is approximately 115, the current SKEW of 144.49 is higher than normal. A trader who is fearful of increasing volatility may want to be cautious.

**How can traders interpret the SKEW Index?
**

While the SKEW index itself cannot be traded, investors may use it to help determining market risk. In general, the SKEW index rises to higher levels as investors become more fearful of a major, unexpected selloff of a large magnitude – a “black swan” event.

As the slope of implied volatility rises, the SKEW Index tends to rise. This may indicate an increase in the probabilities that a major market-moving event is forthcoming. It doesn’t, however, necessarily mean it will happen.

By monitoring the SKEW as it increases over 100, traders may choose to hedge their portfolios, add to current hedges, etc. As with any technical indicator, the SKEW index should be used in conjunction with other technical analysis such as support and resistance, volume, etc.

**Is the SKEW Index related to the VIX?**

The SKEW and VIX indexes are different from each other; yet complementary in terms of measuring the risk of the returns of the S & P 500 over a 30-day period. The VIX is a fairly close representation of the standard deviation of those returns, but this sometimes is not enough to measure the true risk because over time the distribution of the S & P 500 returns exceeds one standard deviation.

The SKEW index describes the tail risk of the distribution; it is a measure of the S & P 500 returns that are greater than two or three standard deviations below (or above) the mean.

Below is a one year daily chart, showing both VIX and SKEW.

Figure D. VIX/SKEW 1 year Daily Chart

Figure D above shows the correlation of SKEW and the VIX. From late December through the middle of January the VIX was hovering around 10 (right axis). At the same time, the SKEW index was in the 120’s to 130’s (black line/left axis). During this period, SPX was continuing to move up in price, as you can see in Figure E below. A trader could interpret this to be an indication of a possible large move in price because SKEW was in the 120 to 130 range. The VIX reached a high of 50.3 on February 6th 2018; at the same time SKEW was around 133.

As with any indicator, signals can be tricky. As an example, please take note of the low price of SKEW (117.99) on January 26, 2018. At the same time the VIX was trading around 10. The SKEW had moved down to 117.99 from its’ previous higher levels, indicating less of a risk of a major market move. This occurred just before the price of SPX started to decline dramatically. A trader may interpret this as a mixed signal.

Figure E. SPX 1 Year Daily Chart

Here’s a good video to watch by Alessio Rastani, which shows other scenarios of the SPX/VIX/SKEW correlation, to forecast a potential large move in the market.

Go to…How to Predict a Fall in the Stock Market

**In summary …
**

A trader cannot use the SKEW Index itself as an instrument to place a trade. What it can do for traders is to measure current market risk. The SKEW index for the most part ranges from 100 to 150. The SKEW Index usually rises in market uncertainty.

The SKEW Index is one more tool for traders to have available to them to make a more informed decision on their positions and portfolio.

Any one indicator you as a trader choose to incorporate into your technical analysis is not going to make you money unless you use it consistently, and this holds true for the SKEW index.

Following the SKEW index along with its relationship to the VIX, as well as price action, may give traders an insight on overall market risk.

If you have found that monitoring the SKEW index has been helpful in your trading and would like to share, feel free to comment below.

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