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.

]]>Two definitions of the word “synthetic” are:

- produced artificially
- devised, arranged, or fabricated for special situations to imitate or replace usual realities

These definitions can describe “Synthetic Positions” in option trading. To understand synthetic option positions (or “synthetics”), we have to understand the basic relationship between puts and calls:

K + C = U + P + I – D

Where

K = Strike Price

C = Call

U = Underlying stock price

P = Put

I = Interest

D = Dividends

For most situations, we can assume interest and dividends are small enough to ignore. We will simplify our equation by excluding them. There are situations where interest and dividends do affect this equation such as high interest rates, long time periods or large dividends for example.

Simplifying our equation, we now have

K + C = U + P

Since the strike price is arbitrary and a constant, let’s remove it from the equation to see what the relationship is between the Call, Put and Underlying security price boils down to:

C = U + P

Long is positive and short is negative. So we have

- +C = Long Call
- -C = Short Call
- +P = Long Put
- -P = Short Put
- +U = Long Stock
- -U = Short Stock

This simple equation let’s you derive the six synthetic relationships quite quickly.

Think back to your algebra class and solve what synthetic you need by putting that variable alone on one side and moving the rest to the other side of the equation. Change the sign when moving from one side to the other of the equation (“jumping the fence as my 8th grade teach used to say”).

**We can now show the six basic relationships**, solved using basic algebra. They are:

- Long Call = Long Stock + Long Put (C = U + P)
- Short Call = Short Stock + Short Put (-C = -U – P)
- Long Put = Long Call + Short Stock (P = C – U)
- Short Put = Short Call + Long Stock (-P = -C + U)
- Long Stock = Long Call + Short Put (U = C – P)
- Short Stock = Short Call + Long Put (-U = -C + P)

**How can we use this knowledge?**

**Hedge an existing position.**

Suppose you have a covered write on a stock but earnings are coming out and you’re worried the stock price might jump around a lot. Or you are going on vacation and don’t want to worry what the market is doing while you’re gone.

Since you know a covered write is identical to a short put synthetically, if you buy a long put, that should completely offset your covered write and completely hedge you while you go through earnings. No need to sell your stock and buy in your short call. Just buy a put. Here’s how that would look:

Notice how the blue line is completely flat. That’s the combined position of the long stock, short call and long put.

**Reverse Market Directional Bias quickly**

Suppose you are bullish on the market and have a Long Call. You change your mind and decide you should be bearish. If you sold your long call and bought long puts, you would have two commissions and two sets of slippage to deal with. Since we know a Long Put = Long Call + Short Stock, all we have to do is SHORT THE STOCK. This changes your position to a synthetic Long Put with one transaction.

This technique is also VERY useful in very fast market conditions. Option bid/ask spreads can really widen during fast markets so your fills closing your Long Call and buying your Long Put might really put you in a hole starting out. Since stocks are very liquid and have very tight bid/ask spreads normally, shorting the stock is a very useful tool to convert your Long Call position during a fast market.

**Closing a position with illiquid options using a box**

This happened to me trading 30 Year Treasury Bond futures options (ZB contract) a few years ago. The bid/ask spread of the in-the-money options was really crazy. (Bid $4, Ask $6 for example). I had a profit in a position that had started out as a butterfly. I could close most of the position with good fills; however, I had some ITM options with very unfavorable bid/ask spreads. What did I do? I built a box!

I had these options I needed to close:

- A long Put at 118 Strike
- A long Call at the 113 strike

To create a riskless position, I did the opposite:

- Short Call at the 118 Strike
- Short Put at the 113 Strike

I ended up with:

- A long Put + Short Call at the 118 strike = a synthetic Short Stock position
- A Long Call + Short Put at the 113 strike = a synthetic Long Stock position
- Which means I was synthetically Long AND Short the stock (which means there’s no risk left)

I hope you’ve seen how useful synthetic option positions can be. There’s more variations but as long as you understand the basic formula of

Long Call = Long Stock + Long Put

You can re-arrange the equation like in algebra class to put the one variable you need by itself and everything else on the other side of the equation to see what the synthetic is.

Are you using synthetics in your 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.

]]>I have the greatest respect for Adam Grimes and have known Adam for several years. I am happy to re-publish Adam's article that was originally published at Adam Grimes's blog.

Most of Adam Grimes's readers know about the Art and Science of Trading course, but, if you don’t, it’s just about the best education in technical analysis that’s available, and it really is completely free. (If you haven’t seen it, you should go check it out.) For at least a few years, Adam had plans to create an options course, and he's excited to tell you The Art & Science of Options launches this week!

One of the reasons this course has taken so long to create is that Adam was looking for the sweet spot in terms of depth and complexity. With options, it’s easy to get deeply involved in specialized concepts and mathematical detours that just don’t matter. (Until they do, and here’s part of the problem!) The other big mistake in options trading is to oversimplify, and there are many people who have built a career, for instance teaching investors at retirement age to write options, on misunderstandings and oversimplifications.

Adam's goal was to create a course that would go in depth enough to understand what you really need to know, but also to be something you could apply pretty quickly. It’s no good if you have to take a college-level math class to think about buying a call! On the other hand, you should understand the risk and potential in any position, and understand how the position will change as the stock moves, volatility changes, and time marches forward.

These things tend to evolve over time, but **ten modules are currently planned**:

**Intro to options**: The very basics, from what an option is to how to read options quotes to some issues you might face when trading. Adam will look at both directional and non-directional strategies, and finish up with an overview of major topic areas in the course.**Option pricing**: Starting with an intuitive approach to “what are these things worth?” Adam will look at the factors that could make an option more or less valuable, and end up looking at some of the standard price models. This is the most conceptual module planned, but it’s important. In fact, it ends with a section called “Why this matters” and it does matter a lot!**Volatility**: When we trade options, we’re really trading volatility. After this module, you’ll understand what volatility is, how it’s measured, and why you should care. Most options education falls flat here, simply telling you, for instance, to sell options that are ranked high on some scanner. We will also take the lessons of cutting-edge quant models and put them into practical lessons any trader can use to understand how volatility is likely to change.**Basic directional strategies**: How to understand the P&L of an options position, trade offs between different strikes and months, and how to execute swing trades with simple options positions.**What you really need to know about the Greeks**: Adam has seen many profound mistakes in this area. It’s easy to get into very complex math that will never matter for most traders, and it’s also very easy to ignore these measures completely—many people running options services will tell you “Greeks don’t matter.” They are wrong; there are things you can only understand if you understand a few key concepts. Adam will show you what you really need to know.**Basic Greeks, applied**: Adam will revisit the basic swing trading ideas, but look at them through the position of Greeks, this time. You’ll see how these measures can simplify your risk management task, and how you can use Greeks to help you pick which specific options to trade. Adam will sneak in the concept of trading option spreads in this module**Spreads**: Most options traders trade spreads, and even those who don’t should understand them! Adam look at the most common and useful spreads and see what markets favor certain structures over others.**Selling options**: Adam will have touched on selling earlier, but this is a module that dives deeply into writing options—why you might want to do it, how to understand the risk, and why it’s not the holy grail it’s often presented as being.**Other strategies**: Adam will have gotten to this point in the course with a heavy focus on just a handful of strategies and structures, and that’s not a mistake—Adam is going to focus on a few trades you can make that offer the flexibility to make trades in a wide range of market conditions. But there are also a few more complex strategies to consider. Even if you’d never actually trade them, exploring trades like calendar spreads and back spreads will cement your understanding of the concepts in the course. (Oh, and someday you’ll find a perfect setup for some of these trades and will be glad you know them well!)**Practical examples**: An in-depth look at what can go right and wrong with examples drawn from recent market action.

The first module of the course will be presented in a live webinar on Thursday February 21 at 17:30 Eastern.

Subsequent modules will be presented as available, but with no more than a week between modules. (In other words, some may be presented back-to-back weeks, and some may have a week in between.) **The full course will only be available to MarketLife Premium or Plus subscribers,** in contrast to the big, free Technical Analysis course, which is, and will always remain, free.

Have you ever been assigned in options trading? Many traders have gone through assignment at some point in their trading life, and it can be an uncomfortable feeling. Today's blog will be a refresher on the “ins and outs” of option assignment. Before I get into the specifics about assignment in options trading, it's worth re-visiting the basics about buying and selling options as it relates to assignment :

**A call option**gives the buyer the right, but not the obligation, to buy a specific underlying at a specific price by a specific date. As the call buyer, you control 100 shares of stock and have the choice whether or not you want to exercise the option. If you exercise, your right is to purchase shares of the stock (100 shares for each option contract). When you buy a call option, you cannot be assigned stock unless you choose to exercise your option. Remember, it is your right, but not your obligation, to exercise that call option.

The seller of the call option will automatically have 100 shares called away from his account if the call buyer exercises his/her option.

**A put option**gives the buyer the right, but not the obligation, to sell a specific underlying at a specific price by a specific date. This means that if the put option expires in the money, the put seller has the obligation to purchase the stock at the same strike price.

As the put buyer, if you exercise your right to sell stock, then the seller will automatically be sold 100 shares of stock per option contract. If the new stock is something the seller wants to keep, he certainly can if he has the available funds in his account. If he chooses to do so, he will now own 100 shares of stock at the strike price per share.

The specific date as defined above is the option's
expiration date. On or prior to the
expiration date, the buyer of the option has the right to exercise the option.
The term “exercise” stands for the process by which the buyer of an
option converts the option into a long stock position in the case of a call, or
a short stock position in the case of a put. ** Buyers of options can exercise. **

**Now, let's talk about the term
“assignment”.**

The term “assignment” refers to the process by
which the seller of an option is notified of the buyer's intention to exercise
that option. The exercise price (strike
price) is the price at which the holder of the option has the right, but not
the obligation, to buy (in the case of a call) or sell (in the case of a put),
the underlying security. **Sellers of options can be assigned.**

**Here is an example of two traders engaging in buying and selling an option:**

**You:**

- You purchased an AAPL (Apple) put option from Joe, at a strike price of $165, for the January 2019 expiration cycle.
- AAPL closed at 156.82 on January 18, which was the option's expiration date. Because AAPL closed below the strike price of $165, the option is expiring in-the-money and you decide to exercise the option.
- You sell 100 shares of AAPL to Joe for $165 per share (the strike price).

**Joe:**

- Joe sold an AAPL put option to you at a strike price of $165.
- The option expired in-the-money and the buyer (you) chose to exercise his option.
- Joe must purchase 100 shares of AAPL stock from you at $165 per share (even if there is not adequate capital in his account).

**What happens next?**

If Joe does not have sufficient funds in his account to purchase the stock, he will still own it, but for a short time. Joe will be required to close the position immediately (usually because Joe receives a margin call from his broker). Joe will also be charged an assignment fee, which varies depending on his broker, as well as commissions.

**The 3 most common questions related
to trading options and being assigned stock are:**

*What situations would cause me to get assigned stock?*

When **you’re the option buyer, you have the power to assign**. If
you are the option seller, that is a different story…

When you** sell an option** (a call or a put), **you will be assigned stock if your option
is in-the-money at expiration**. As the option seller, you have no
control over assignment, and it is impossible to know exactly when this could
happen. Generally, assignment risk becomes greater closer to
expiration. Having said that, however, assignment
can still happen at any time.

An important note to remember is there is additional assignment risk when the underlying's company has upcoming dividends (dividends are when a company distributes cash to their shareholders). Essentially, if the extrinsic value on an ITM short call is LESS than the dividend amount, the ITM call owner will have good reason to exercise their option so that they can realize the dividend associated with owning the stock. If you would like to read more about the intrinsic and extrinsic value of options, I published an article on August 17, 2018 titled “What are Intrinsic & Extrinsic Option Values”? That article can be found here: https://aeromir.com/00182/what-are-intrinsic-and-extrinsic-option-values

s* 2. What can I do to help prevent being assigned stock? There are two ways:*

- You can close the trade before it expires and take any profit or loss on the trade.
- You can roll the trade to another expiration cycle to extend the days to expiration. This will give you more time to be right on your original entry premise.

* 3. And…If I am assigned, what should I do?*

Assignment can happen pretty easily if you are not monitoring your positions on a regular basis (and can also happen even if you are). There are two things that can happen if you sold an option that has expired in the money…

- If you were assigned stock and had the money to cover the shares in your account, then you can choose to hold the long (or short) stock, or buy/sell the shares back for a profit or loss. Some traders assigned stock, and have the sufficient funds, may choose to retain the stock and write covered calls against it. This may be a strategy if you feel the stock will rebound over time; writing covered calls in the meantime can be a way to recover some of the realized loss as a result of being assigned.
- If you were assigned shares and don't have the money to cover the shares you were assigned (the term for this is a margin call), you will need to buy/sell back the shares ASAP. If you do not, the broker will do it for you before the end of the trading day.

**Doesn't the use of vertical spreads versus long options
minimize the risk of assignment?**

When you sell a put spread or call spread, the assignment risk comes from your short strike expiring in- the-money . If both strikes expire in the money, they will essentially cancel each other out and you will not be assigned.

If you sell a call spread and the short strike is in the money at expiration, you will be forced to sell 100 shares per option contract to the buyer. If you sell a put spread and just the short strike is in the money at expiration, you will be assigned 100 shares of stock per contract.

**In summary, here are a
few things to keep in mind regarding assignment:**

- Assignment can happen at any time – it is more likely to occur at expiration; but remember it is controlled by the option buyer.
- If you do not have funds in your account to cover long or short stock, you will be required to close the position immediately.
- Vertical spreads give more protection against being assigned, but they do not protect you unless BOTH legs are in the money.
- If you have a short call position, there is additional assignment risk if that call is in the money at the time of the dividend.

Whether you are new to trading or a veteran looking to share your trade experiences with others, Aeromir is the place. We offer mentoring, educational trade alert services, and trading groups that meet on a regular basis.

I hope this article reduces any uncertainties you may have on assignment in options trading. If you have an experience on being assigned that you would like to share with others, feel free to comment below.

]]>Charles Cottle and Ali Pashaei presented “Surviving and Thriving in Volatile Markets” on Friday. They showed how they navigated the large move down and did well protecting their portfolios.

Charles and Ali teach group mentoring classes at Aeromir.com. They are offering 15% to 30% discounts to their recorded classes but you have to act before midnight Eastern on Friday January 25, 2019.

To see what Charles and Ali have been teaching, please visit these pages:

To order discounted recorded classes, please click on this button:

Enjoy the replay!

]]>Charles Cottle and Ali Pashaei are presenting a free webinar of how to survive and thrive in volatile markets

The webinar will be Friday, 18 January 2019 at 11:00am Eastern.

>>> Register for the webinar <<<

The webinar should be approximately 60-minutes but may go over if there are enough questions.

The webinar will be recorded and posted on our YouTube channel. Consider subscribing to our YouTube channel to be notified when the recording is ready.

]]>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.

]]>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!

]]>Marko, from OptionSlam.com, is presenting the Double Eagle Trade on the Aeromir Round Table on Wednesday, 10 October 2018 at 11:00am Eastern.

The Double Eagle Trade is a pre-earnings trading discipline with an excellent track record. We know you'll enjoy the presentation.

Marko is teaching a workshop on the Double Eagle next weekend.

We look forward to seeing you on the webinar!

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