Feb
17
2022
What Is a Calendar Spread Option?

What Are Calendar Spreads and How Do They Work?

By | Growing Wealth, invest, Investing | Comments Off on What Are Calendar Spreads and How Do They Work?

Many options spread strategies consist of buying and selling call or put options that expire at the same time. Calendar spreads, on the other hand, are created by selling a short-dated option and buying a longer-maturity option with the same strike price. Rather than seeking favorable directional movement in the underlying stock, the calendar spread takes advantage of implied volatility and the way that it typically changes over time.

Like other option spread strategies, a calendar spread limits a trader’s potential losses, but it also caps their potential return. Calendar spreads are considered an advanced option trading strategy, so it’s important to have a handle on how they work and the potential risks. Read on to learn more about how to build calendar spreads and when to use them.

Calendar Spreads Defined

A calendar spread, also known as a horizontal spread, is created with a simultaneous long and short position in options on the same underlying asset and strike price but different expiration dates. Calendar spreads can be constructed using calls or puts. The longer-dated option is purchased and the shorter-dated option is sold. Typically, the option that is sold has a near-term expiration date.

How Calendar Spreads Work

Calendar spreads are typically established for a net debit, meaning you pay at the outset of the trade. This is because generally speaking, a longer-dated option will be more expensive than a shorter-dated one if the strike prices are the same.

Time decay is essential to how calendar spreads work. It tends to accelerate as an option’s expiration approaches, which means that all else equal, the short-dated option will lose more value due to time decay than the long-dated option over a given passage of time. If the stock price is at or near the strike price of the options at the time of the first expiration date, the trade should be profitable.

Calendar spreads function fairly similarly whether constructed with calls or puts. Depending on where the stock price is relative to the strike price selected at the outset of the trade, and whether calls or puts are used, a calendar spread can be neutral, slightly bearish, or slightly bullish.

Maximum Profit on Calendar Spread

A calendar spread strategy hits max profit when the stock price settles at the near-term strike price by that option’s expiration. That is not the end of the trade, however. The trader benefits when the stock price rises after the near-dated option’s expiration since they are long the later-date call option.

A rise in implied volatility after the front-month call expires also benefits the later-dated long options position. However, some traders might choose to close the later-dated option position when the near-dated option expires.

Maximum Loss on Calendar Spread

A calendar spread is considered a debit spread since the cost of the later-dated option is greater than the proceeds from the near-date option’s sale. So the trader can not lose more than the premium paid.

Breakeven

The precise breakeven calculation on a calendar spread option trade cannot be determined due to the two different option delivery dates. Traders must estimate what the value of the long-dated option contract will be on the near-dated option’s expiry.

One way to this is using online option strategy profit and loss calculator to estimate a breakeven price. Changing option Greeks – such as implied volatility levels and market interest rates – also make deriving a breakeven price difficult to pin down on this strategy.

Calendar Spread Example

An example helps to understand how calendar spread options work. Suppose XYZ stock is $100, and the trader believes the stock price will not change much in the next month. Based on that neutral thesis, the trader sells a $100 call option expiring in one month for $10 and buys a call at the same $100 strike price that expires in two months at a price of $15. The net debit is $5. The later-dated call option is more expensive because it has more time value than the near-dated call.

Over the next month, the stock fluctuates since the trade was executed, but settles back to $100 on the afternoon of the front-month’s option delivery date. Since time has passed and the stock has not drifted from $100, the near-dated call option has lost considerable time value. The short call expires worthless. The later-dated call is now worth $10.

The trade worked well. The trader exits the position by allowing the near-term call to expire worthless and selling to close the $10 later-dated long call. In essence, the trader made $10 on the short call and lost $5 on the long call for a profit of $5.

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Calendar Spread Payoff Diagram

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Source: https://www.warriortrading.com/calendar-spread-definition-day-trading-terminology/

Calendar Spread Risks

There are several risks that traders must keep in mind when using calendar spreads.

Limited Upside

This is the main risk in calendar spread strategies, if the trade closes at the near-dated option’s expiry. The options trader benefits from time decay and increases in implied volatility. Once the short option expires or is bought to close, there is unlimited upside potential with the remaining long call. If the trader uses puts they have a significant upside if the stock price goes to zero.

Delivery Dates

Trader must make a choice when the near-dated option is on the precipice of expiring. The trader can let it expire if it is out of the money, but if it is in the money, then it might be worthwhile to buy to close the option.

Timing the Trade

Being correct about the near-term direction of the stock, as well as changes in implied volatility and time decay, can be challenging.

Types of Calendar Spreads

There are several types of calendar spreads. Here’s a look at some of the most popular strategies.

Put Calendar Spread

A calendar put spread option is a strategy in which a trader sells a near-dated put and buys a longer-dated put. A trader would put this trade on when they are neutral to bullish on the price change of the underlying stock in the near-term. Once again, this type of calendar spread options strategy aims to benefit from time decay or higher implied volatility.

Calendar Call Spread

A calendar call spread involves shorting a near-term call and buying a longer-dated call at the same strike. (This is the strategy outlined in the earlier example.) The near-term outlook on the underlying stock is neutral to slightly bearish while the trader might have a longer-term bullish view.

Diagonal Calendar Spread

A diagonal calendar spread uses different strike prices for the two options positions. This strategy still uses two options – either two calls or two puts – with different expiration dates. This strategy can be either bullish or bearish depending on how the trade is constructed. The term diagonal spread simply refers to the use of both a calendar spread (horizontal) and a vertical spread.

Short Calendar Spread

Traders can use a short calendar spread with either calls or puts. It is considered a “short” calendar spread options strategy because the trader buys the near-dated option while selling the longer-dated option. This is the opposite of a long calendar spread. A short calendar spread profits from a large move in the underlying stock.

Trading Stocks with SoFi

Calendar spreads are useful for traders who want to profit from changes in stock variables other than price direction. They’re an advanced strategy, however, that may not make sense for beginner investors.

However, you do not need to use any options at all to build a portfolio that helps you meet your goals. SoFi does not currently offer options, but it does provide an easy way to start building a portfolio. By opening an online brokerage account on the SoFi Invest® investment app, you can start trading in individual equities, fractional shares, and exchange-traded funds (ETFs) directly from your phone.

Photo credit: iStock/Tatomm

SoFi Invest®

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
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Feb
10
2022
SPAN Margin: How it Works, Pros & Cons

SPAN Margin: How It Works, Pros & Cons

By | Growing Wealth, invest, Investing, Terminology | Comments Off on SPAN Margin: How It Works, Pros & Cons

Options trading is far more complex than trading stocks and exchange-traded funds (ETFs). Trading and valuing options includes many variables including intrinsic value and time value, implied volatility, and weighing changes in interest rates.

The SPAN system determines margin requirements on options accounts by considering many inputs along with a portfolio’s global (total) assets to conduct a one-day risk assessment. This article will dive deep into how SPAN works and what investors need to know about it.

What Does SPAN Stand For?

SPAN stands for standardized portfolio analysis of risk, and is an algorithm used in options and futures margin trading.

What Is SPAN Margin?

The SPAN margin calculation helps options traders understand risk in their accounts and assists brokers in managing risk. SPAN is used by options and futures exchanges around the world to determine a trader’s one-day worst-case scenario based on their portfolio positions. Margin requirements can be set in an automated way from the calculation’s output.

Unlike the margin in a stock trading account, which is essentially just a loan from a broker, the margin in an options or futures account is considered a good-faith deposit or a performance bond. It is helpful to understand how a margin account functions before trading complex strategies.

How Does SPAN Margin Work?

The SPAN margin calculation uses modeled risk scenarios to determine margin requirements on options and futures. The primary variables included in the algorithm are strike prices, risk-free interest rates, price changes in the underlying assets, volatility shifts, and the effect of time decay on options.

While buying options typically does not require margin, writing (or shorting) options requires a deposit. In essence, the options seller exposes the broker to risk when they trade. To reduce the risk that the trader cannot pay back the lender, margin requirements establish minimum deposits that must be kept with the broker.

Rather than using arbitrary figures, the SPAN system automates the margin setting process, using algorithms and many sophisticated inputs to determine margin requirements. SPAN margin looks at the worst-case scenario in terms of one-day risk, so the margin requirement output will change each day.

The analysis is done from the portfolio perspective since all assets are considered. For example, the SPAN margin calculation can take excess margin from one position and apply it to another.

SPAN margin also imposes requirements on options and futures contract sellers, known as writers. Traders who are short derivatives contracts often expose the lender to greater risk since losses can be unlimited depending on the positions taken. The broker wants to ensure their risk is protected if the market turns against options and futures writers.

Pros and Cons of SPAN Margin

There are upsides and downsides to SPAN margin in options and futures trading.

The Advantages

Futures options exchanges that use the SPAN margin calculation allow Treasury Bills to be margined. Though fees are typically also imposed by many clearinghouses, the interest earned on the Treasurys may help offset transaction costs if interest rates are high enough.

There is another upside: Net option sellers benefit from SPAN’s holistic portfolio approach. SPAN combines options positions when assessing risk. If you have an options position with a substantial risk in isolation but another options position that offsets that risk, SPAN considers both. The effect is a potentially lower margin requirement.

The Downsides

While SPAN is savvy enough to look at both pieces of an option seller’s combination trade, there are never perfect hedges. Many variables are at play in derivatives markets. There can still be strict margin levels required based on SPAN margin’s one-day risk assessment.

Summary

Pros

 Cons
Determines margin requirements from an overall portfolio perspective There still might be high margin requirements when two positions do not offset
Traders know their margin amount each day based on the latest market variables Changing market conditions can mean big shifts in day-to-day SPAN margin amounts
Margin deposits in options or futures accounts can collect interest

SPAN and Exposure Margin

Exposure margin is the margin blocked over and above the SPAN margin amount to protect against any mark-to-market losses. Like SPAN margin, exposure margin is set by an exchange. The exchange will block off your entire initial margin (both SPAN margin and exposure margin) when you initiate a futures transaction.

The Takeaway

SPAN margin is helpful to manage risks in trading markets. Algorithms determine margin requirements based on a one-day risk analysis of a trader’s account. While primarily used in futures trading and when writing options, investors should know about this critical tool in financial markets.

Margin accounts come with a unique set of risks and rewards. You can learn more about margin trading with SoFi’s resources.

You can also explore investing options on the SoFi Invest® app. It allows members to research investment opportunities based on their individual risk and return objectives.

Find out how to get started at SoFi Invest.

FAQ

What does SPAN stand for in margin trading?
SPAN margin stands for “standardized portfolio analysis of risk.” It is a system used by many options and futures exchanges worldwide.

How is SPAN margin used?

SPAN margin is used to manage risk in trading markets. It calculates the suggested amount of good-faith deposit a trader must add to their account in order to engage in options or futures trading. To help mitigate the risk that traders will not be able to pay back the funds the broker lends them, exchanges use the SPAN system to calculate a worst possible one-day outcome and set a margin requirement accordingly. SPAN margin reduces the risk of a trader growing their leverage ratio too high based on the automated risk calculations. SPAN margin can also allow lower margin requirements for options sellers who trade multiple positions.

What is a SPAN calculation?

SPAN is calculated using risk assessments. That means an array of possible outcomes is analyzed based on different market conditions using the assets in a portfolio. These risk scenarios specify certain changes in variables such as price changes, volatility shifts, and decreasing time to expiration in options trading.

Inputs into a SPAN calculation include strike prices, risk-free interest rates, price changes in underlying assets, implied volatility changes, and time decay. After calculating the margin on each position, SPAN can shift excess margin on a single position to other positions that might be short on margin. It is a sophisticated tool that considers a trader’s entire portfolio.

Photo credit: iStock/NakoPhotography

SoFi Invest®

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

*Borrow at 12%. Utilizing a margin loan is generally considered more appropriate for experienced investors as there are additional costs and risks associated. It is possible to lose more than your initial investment when using margin. Please see SoFi.com/wealth/assets/documents/brokerage-margin-disclosure-statement.pdf for detailed disclosure information.
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Feb
10
2022
What Is a Naked Call Options Strategy?

What Is a Naked Call Options Strategy?

By | Growing Wealth, invest, Investing | Comments Off on What Is a Naked Call Options Strategy?

A naked call, or uncovered call, is an aggressive, high-risk option strategy. It occurs when an investor sells or writes call options for which they don’t own the underlying security. The seller is betting that the underlying stock price will not increase before the call’s expiration date.

It is safer for traders to sell calls on a stock they already own. This way, if the stock price increases sharply, the trader’s net position is hedged. A hedged position, in this example, means that as the stock value rises, the long-stock position grows while the short-call option position loses. This situation describes a “covered call” position, which is a much lower risk strategy.

Naked calls, on the other hand, are speculative trades. You keep the premium if the underlying asset is at or in the money at expiration, but you also have the potential for unlimited losses. Read on for more about what naked calls are, how they work, their risks and rewards, and more.

Understanding Naked Calls

When a trader sells or writes a call option, they are selling someone else the right to purchase shares in the underlying asset at the strike price. In exchange, they receive the option premium. While this immediately creates income for the option seller, it also opens them up to the risk that they will need to deliver shares in the underlying stock, should the option buyer decide to exercise.

For this reason, it is significantly less risky to use a “covered call strategy” or sell an option on an underlying asset that you own. In the case of stocks, a single option generally represents 100 shares, so the trader would want to own 100 shares for each option sold.

Trading naked calls, on the other hand, is among the more speculative options strategies. The term “naked” refers to a trade in which the option writer does not own the underlying asset. This is a neutral to bearish strategy in that the seller is betting the underlying stock price will not materially increase before the call option’s expiration date.

In both the naked and the covered scenarios, the option seller gets to collect the premium as income. However, selling a naked call requires a much lower capital commitment, since the seller is not also buying or owning the corresponding number of shares in the underlying stock. While this increases the potential return profile of the strategy, it opens the seller up to potentially unlimited losses on the downside.

How Do Naked Calls Work?

The maximum profit potential on a naked is equal to the premium for the option, but potential losses are limitless. In a scenario where the stock price has gone well above the strike price, and the buyer of the option chooses to exercise, the seller would need to purchase shares at the market price and sell them at the strike price. Hypothetically, a stock price has no upper limit, so these losses could become great. When writing a naked call, the “breakeven price” is the strike price plus the premium collected; a profit is made when the stock price is below the breakeven price.

Investing in naked calls requires discipline and a firm grasp on common options trading strategies.

Writing a Naked Call

While there are significant risks, the process of naked call writing is relatively easy. An individual enters an order to trade a call option, but instead of buying they enter a sell-to-open order. Once sold, the trader hopes the underlying stock moves sideways or declines in value.

So long as the shares do not rise quickly, and ultimately remain below the strike price at expiration, the naked call writer will keep the premium collected (also known as the credit). Unexpected good news or simply positive price momentum can send the stock price upward, leading to higher call option values.

On the most common stocks and exchange-traded funds (ETFs), there are dozens of option strike prices at various expiration dates. For this reason, a trader must make both a directional bet on the underlying stock price and a time-wager based on the expiration date. Keeping a close eye on implied volatility is important, too.

Closing Out a Naked Call

When the trader wants to exit the trade, they punch in a buy-to-close order on the short calls. Alternatively, a trader can buy shares of the underlying asset to offset the short call position.

Finally, user-friendly options trading is here.*

Trade options with SoFi Invest on an easy-to-use, intuitively designed online platform.

*Check out the OCC Options Disclosure Document.

Naked Call Example

Let’s say a trader wants to sell a naked call option on shares of XYZ. Let’s also assume the stock trades at $100 per share.

For our example, we will assume the trader sells a call option at the $110 strike price expiring three months from today. This option might have a premium, or cost, of $5. The call option is said to be “out of the money” since the strike price is above the underlying stock’s current price.

Thus, the option only has extrinsic value (also known as time value). This naked call example seeks to benefit from the option’s time decay, also known as its theta. At initiation, the trader sells to open, then collects the $5 premium per share.

The trade’s breakeven price is $115 ($110 strike price plus $5 premium). Jump ahead a month, and shares of XYZ have rallied to $110. The value of the $110 strike call option, now expiring in just 60 days, is worth $9 since the share price rose $10.

On the other hand, the option’s time value dropped modestly since the expiration date drew closer. After pocketing the $5 premium at the trade’s initiation, the trader effectively owes $9 back, resulting in a net loss on paper.

Fast-forward to the week of expiration: XYZ’s stock price has fallen to $100. The $110 call option with just a few days left until expiration – Friday, is worth just $0.50 of time value with no intrinsic value. The trader chooses to close the trade with a buy-to-close order to lock in that $0.50 price.

In summary, the trader collected the $5 premium at the onset of the trade, experienced paper losses when XYZ’s stock price rose, but then ended on the winning side of the ledger by expiration when the position closed. The traders realized a profit of $4.50 considering the $5 sell and $0.50 buy-back. The trader could have also allowed the option to potentially expire worthless, which could have netted a $5 profit.

Using Naked Calls

Trading naked calls sometimes appeals to new traders who do not fully grasp risk and return probabilities. The notion that you can make money simply if a stock price or ETF does not go up in value sounds great. The problem arises when the underlying security appreciates quickly.

A naked call writer might not have enough cash to close the position. For this reason, brokers often have margin requirements on traders seeking to sell naked calls. When an account’s margin depletes too far, the broker can issue a margin call requiring the trader to deposit more cash or assets.

In general, naked calls make the most sense for experienced traders who have a risk management strategy in place before engaging in this type of trade.

Risks and Rewards

The potential for unlimited losses makes naked call writing a risky strategy. The reward is straightforward — keeping the premium received at the onset of the trade. Here are the pros and cons of naked call option trading:

Pros

 Cons
Potential profits from a flat or declining stock price Unlimited loss potential
Allows theta to work in your favor Reward limited to the premium collected
Generates income Margin calls when the underlying appreciates

Naked Call Alternatives

A common alternative to selling a naked call is to simply own the stock then sell calls against that position. This technique is known as “covered call writing”. This is a safer alternative to risky naked calls, but the trader must have enough cash to purchase the necessary shares.

One options contract covers 100 shares, so purchasing 100 shares of XYZ at $100 per share requires $10,000 of capital, unless the investor makes use of margin trading.

Other complex options strategies can achieve results similar to naked call writing. Covered puts, covered calls, and bear call spreads are common alternatives to naked calls. Experienced options traders have strategies to manage their risk, but even sophisticated traders can become overconfident and make mistakes.

Selling naked puts is another alternative that takes a neutral to bullish outlook on the underlying. When selling naked puts, the trader’s loss potential is limited to the strike price (minus the premium collected) since the stock can only go to $0.

The Takeaway

A naked call strategy is a high-risk technique in which a trader seeks to profit from a declining or flat stock price. The maximum gain is the premium received while the risk is unlimited potential losses. As with all option trading strategies, traders need to understand the risks and benefits of selling naked calls.

To make informed options trading decisions, it can help to have a platform that offers educational resources you can reference along the way. SoFi’s options trading platform offers a library of such resources, as well as an intuitive and approachable design. Plus, investors have the choice of trading options either on the mobile app or the web platform.

Trade options with low fees through SoFi.

Photo credit: iStock/twinsterphoto

SoFi Invest®

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
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Feb
10
2022
Trading Futures vs. Options: Key Differences to Know

Futures vs Options: What Is the Difference?

By | Growing Wealth, invest, Investing | Comments Off on Futures vs Options: What Is the Difference?

Futures and options are similar in that they are both derivative contracts between a buyer and seller to trade an asset at a certain price, on or before a certain date. Investors can use these instruments to hedge against risk and potentially earn profits — but options and futures function quite differently.

Options are derivatives contracts that give buyers the right, but not the obligation, to buy (in the case of a call) or sell (in the case of a put) an asset at a specified price within a certain period of time.

Futures are another type of contract in which buyers and sellers are obligated to trade a specific asset on a certain future date, unless the asset holder closes their position prior to the contract’s expiration. A futures contract consists of a long side and a short side, where the short side is obligated to make delivery of the underlying asset, and the long side is obligated to take it.

Both options and futures typically employ some form of financial leverage or margin, amplifying gains and losses, creating a greater level of risk.

Futures

 Options
Buyer is obliged to take possession of the underlying asset, or make a trade to close out the contract. Buyer has the right, but not the obligation, to buy or sell a certain asset at a specific price.
Futures typically involve taking much larger positions, which can involve more risk. Options may be less risky because the investor is not obliged to acquire the asset.
No upfront cost to the buyer, other than commissions. Buyers pay a premium for the options contract.
Price can fall below $0. Price can never fall below $0.

Options Explained

Options are contracts that establish an agreement for the trade of a certain underlying asset, such as a stock or currency. An options contract typically reflects 100 shares of the asset.

Buyers of options have the right to buy or sell the asset, but they are not required to. These contracts are known as derivatives because they are tied to the underlying assets they represent but are not the assets themselves.

To enter into an options contract, the buyer pays what is known as a premium in options terminology. The premium is non-refundable, so that is what the buyer risks when they enter the contract.

Types of Options

The two types of options are call options and put options.

•   Call options, or calls, allow the option holder to buy an underlying asset at the strike price any time until the expiration date.

•   Put options, or puts, allow the option holder to sell an asset at a certain price for the duration of the contract.

Example of a Call Option

An investor buys a call option for XYZ stock with a strike price of $40 per share, paying a $3 premium to enter into the contract. The contract expires in six months, and the stock is currently trading at $39 per share.

Within the next six months, if the stock price goes up to $50, the buyer can choose to exercise their call option and purchase the stock at the $40 strike price. They could then sell that stock on the market for $50 per share and make a $10 per share profit, minus the cost of the premium.

Or, the buyer could choose to sell the option itself rather than exercising it and buying the shares. The contract will have gone up in value as the price of the stock went up, so the buyer would likewise see a profit.

If the price of the stock is below the $40 strike price at the time of expiration, the contract would expire worthless, and the buyer’s loss would be limited to the $3 premium they paid upfront.

Example of a Put Option

Meanwhile, if an investor owns a put option to sell XYZ stock at $80, and XYZ’s price falls to $60 before the option expires, the investor will gain $20 per share, minus the cost of the premium.

If the price of XYZ is above $80 at expiration, the option is worthless, and the investor loses the premium paid upfront.

Who Trades Options

Experienced investors who are able to buy and sell on margin are typically those who trade options contracts.

Because options investing entails a certain amount of risk, as well as access to a margin account, retail investors may need approval from their brokerage in order to trade options.

Futures Explained

Futures contracts are similar to options in that they set a specific price and date for the trade of an underlying asset. One of the most common forms are futures on commodities, which speculators can use to make a profit on changes in the market without actually buying or selling the physical commodities themselves. Futures are also available for individual stock market indices and other assets. Rather than paying a premium to enter the contract, the buyer pays a percentage of the notional value called an initial margin.

Example of a Futures Contract

Let’s look at an example of a futures contract. A buyer and seller enter a contract that sets a price of $40 per bushel of wheat. During the life of the contract, the market price may move above $40, putting the contract in favor of the buyer, or below $40, putting it in favor of the seller. If, for example, the price of wheat goes to $45 at expiration, the buyer would make $5 per bushel, multiplied by the number of bushels the contract controls.

Who Trades Futures?

Some of the most commonly traded futures contracts are related commodities, including agricultural products (e.g. wheat, soybeans), energy (e.g. oil), and metals (e.g. gold. silver). There are also futures on major stock indices, such as the S&P 500, government bonds, and currencies.

Traders of futures are generally divided into two camps: hedgers and speculators. Hedgers typically have a position in the underlying commodity and use a futures contract to mitigate the risk of future price movements. An example of this is a farmer, who might sell a futures contract against a crop they produce, to hedge against a fall in prices and lock in the price at which they can sell their crop.

Speculators, on the other hand, take some risk in order to profit from favorable price movements in the underlying asset. These include institutional investors, such as banks and hedge funds, as well individual investors. Futures enable speculators to take a position on the price movement of an asset without trading the actual physical product. In fact, much of trading volume in many futures contracts comes from speculators rather than hedgers, and so they provide the bulk of market liquidity.

Futures vs Options: Main Differences

So far, we’ve described some of the differences in how options and futures are structured and used. Here are some additional factors to consider when comparing the two instruments.

Risk

Trading options comes with certain risks. The buyer of an option risks losing the premium they paid to enter the contract. The seller of an option is at risk of being required to purchase or sell an asset if the buyer on the other side of their contract exercises the option.

Futures can be riskier than options because of the high degree of leverage they offer. A trader might be able to buy or sell a futures contract putting up only 10% of the actual value. This leverage magnifies price changes, meaning even small movements can result in substantial profit or loss.

With futures, the value of the contract is marked-to-market daily, meaning each trading day money may be transferred between the buyer and seller’s accounts depending on how the market moved. An option buyer, on the other hand, is not required to post any margin, since they paid the premium upfront.

Value

Futures pricing is relatively intuitive to understand. The price of a futures contract should approximately track with the current market price of the underlying asset, plus the cost of carrying or storing the physical asset until maturity.

Option pricing, on the other hand, is generally based on the Black-Scholes model. This is a complicated formula that requires a number of inputs. Changes in several factors other than the price of the underlying asset, including the level of volatility, time to expiration, and the prevailing market interest rate can impact the value of the option.

Holding constant the price of the underlying asset, futures maintain their value over time, whereas options lose value over time, also known as time decay. The closer the expiration date gets, the lower the value of the option gets. Some traders use this as an options trading strategy. They sell options contracts, knowing that time decay will eat away at their value over time, betting that they will expire worthless and pocketing the premium they collected upfront.

The Takeaway

Futures and options are popular types of investments for those interested in speculation and hedging. But these two types of derivatives contracts operate quite differently, and present different opportunities and risks for investors.

There are several differences between futures and options, most notably that futures contracts specify an obligation — for the long side to buy, and for short side to sell — the underlying asset at a specific price on a certain date in the future On the other hand, options contracts give the contract holder the right to buy or sell the underlying asset at a specific price, but not the obligation to do so (which removes some of the risk).

Another distinction, though, is that a futures contract is a simpler transaction in a way, as it only involves a buyer who wants to buy the contract/asset, and the seller who wants to sell it. Options, however, come in two flavors, puts and calls, which involve different rules and potential outcomes. Puts give investors the option to buy a certain asset, while calls give investors the right to sell a certain asset.

If you’re interested in getting started with trading options, SoFi now offers an options trading platform. This intuitive and approachable platform allows users to trade options from the web platform or mobile app. Plus, you’ll have a library of educational content at your fingertips to continue learning as you trade.

Pay low fees when you start options trading with SoFi.

Photo credit: iStock/DonnaDiavolo

SoFi Invest®

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
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Feb
10
2022
What Is Max Pain in Options Trading?

What Is Max Pain in Options Trading?

By | Growing Wealth, invest, Investing | Comments Off on What Is Max Pain in Options Trading?

What Is Max Pain?

Max pain, or the maximum pain price, is the strike price with the most open options contracts combining puts and calls. It is the strike price that causes the highest dollar value of losses among option buyers on a given stock at a specific expiration.

According to the Chicago Board Options Exchange (CBOE), about 30% of options expire worthless, 10% are exercised, and 60% close out before expiration. The concept of max pain focuses on the 30% of options that expire with no intrinsic value.

Some large institutional options sellers see an investment opportunity in writing options that eventually expire worthless, according to max pain theory. If options expire worthless, the seller of those options keeps the entire premium as profit.

Max pain options trading stems from the Maximum Pain Theory. The theory contends that option sellers seek to hedge portfolios with options expiration. The Maximum Pain Theory also suggests an option’s price will arrive at a max pain price where the most options contracts held through expiration will experience losses. Bear in mind that an options contract that is not “in the money” at expiration is worthless.

Recommended: Popular Options Trading Terminology to Know

How Max Pain Works

The Maximum Pain Theory asserts that the price of the underlying asset is likely to converge at the maximum pain strike price. The max pain price is the strike with the greatest dollar value of calls and puts. As the expiration date approaches, the underlying stock price might “pin” to that option strike price.

Some day traders closely monitor the max pain price on the afternoon of expiration – usually the third Friday of the month for monthly options or each Friday for weekly options contracts.

Max Pain trading can be controversial, as some believe it borders on “market manipulation” when traders seek to pin a stock price to a certain price at a certain time. Market participants disagree about whether or not Max Pain Theory works in practice. If a trader can predict which strike price will feature the greatest combination of dollar value between calls and puts, the theory states that they could profit from using that information.

Some market makers may consider Max Pain Price Theory when hedging their portfolios. Delta hedging is a strategy used by options traders – often market makers — to reduce the directional risk of price movements in the security underlying the options contracts. A market maker is often the seller of options contracts, and they seek to hedge the risk of options price movements by buying or selling underlying shares of stock.

This activity can cause the stock price to converge at the max pain price. Delta hedging plays a significant role in max pain trading.

How to Calculate the Max Point

Calculating the max pain options price is relatively straightforward if you have the data. Follow these steps to determine the max pain strike:

•   Step 1: Calculate the difference between each strike price and the underlying stock price.

•   Step 2: Multiply the results from Step One by the open interest at each strike.

•   Step 3: Add the dollar value for both the put and the call at each strike.

•   Step 4: Repeat Steps One through Three for each strike price on the option chain.

•   Step 5: The strike price with the highest dollar value of puts and calls is the max pain price.

Since the stock price constantly changes and open interest in the options market rises and falls, the max pain price can change daily. An options trader might be interested to see if there is a high amount of open interest at a specific price as that price could be where the underlying share price gravitates toward at expiration, at least according to Max Pain Theory.

Max Pain Point Example

Let’s assume that XYZ stock trades at $96 a week before options expiration. A trader researches the option chain on XYZ stock and notices a high amount of open interest at the $100 strike. The trader performs the steps mentioned earlier to calculate the max pain price.

Indeed, $100 is the max pain price. Since the trader believes in Max Pain Theory, they go long shares of XYZ on the assumption that it will rise to $100 by the next week’s options expiration. Another options trading strategy could be to put on a bullish options position instead of buying shares of the underlying stock.

This hypothetical example looks simple on paper but many factors influence the price of a stock. There could be company-specific news issued during the final days before expiration that sends a stock price significantly higher or lower.

Macro factors and overall market momentum might overwhelm market makers’ attempt to pin a stock to a max pain strike. Finally, stock price volatility could cause the max pain price to shift in the hours and even minutes leading up to expiration.

Pros and Cons of Using Max Pain Theory When Trading

Max Pain Options Theory can be an effective strategy for options traders looking for a systematic approach for their options strategy. That said, not everyone agrees that Max Pain Theory works in practice. Here are some of the pros and cons of Max Pain Theory.

Pros

 Cons
A systematic approach to trading options Lack of agreement supporting the theory
Trades the most liquid areas of the options market Stock prices don’t always gravitate to a max pain price
Benefits from supposed market manipulation Other factors, such as market momentum or company news, could move the stock price

Max pain trading in the options market is easier today amid a brokerage world with low or even no commissions. Previously, it was simply not economical for many retail traders with small account sizes to buy and sell options using max pain theory.

Critics contend that there should be more regulatory oversight on max pain price trading — particularly on large institutions that could be manipulating prices. It’s unclear whether there will be more oversight of such practices in the future.

The Takeaway

Max Pain Theory is one approach to options trading based on the strike price that would cause the most losses. Options traders who calculate the max pain price, can use that information to inform their investing strategy. But it’s not necessary to invest in options at all to build your nest egg.

But if you’re ready to tackle options trading, check out the SoFi options trading platform. Investors can trade options either from the mobile app or web platform, with an intuitive and approachable design. Whether you’re a seasoned trader or an options trading beginner, you might also perusing the educational content about options offered, too.

Trade options with low fees through SoFi.

Photo credit: iStock/valentinrussanov

SoFi Invest®

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
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