Category: How the Market Works

A 112 Cautionary Tale

On August 5, 2024, the volatility index, VIX, spiked to 65, the fastest spike in Implied Volatility ever recorded. Anyone with significant holdings in naked options, including the 112, likely took significant losses.

The August 5, 2024 VIX Explosion Impact

In August 5, 2024 pre-market trading, the volatility index, VIX, spiked to 65, although the market was only down a moderate amount. The market had the fastest spike in Implied Volatility ever recorded, and anyone with significant holdings in naked options, and especially the 112, likely took significant, if not catastrophic losses.

Stock traders shrugged, but option traders, especially short in futures options, saw premiums explode to extreme levels. Short traders saw margin requirements explode and marked positions move to 10, 20, or even 30 times the initial amount collected in losses they couldn’t escape in illiquid markets.

The 112 trade, which is written about on this site in several places, was the poster child for big losses. Often traders use futures options that are leveraged to the max using SPAN margin. The trade promises to have a buffer of a 1-1 debit spread to provide a barrier from big losses in downturns. The 2 other short strikes are set to be so far out of the money that they should almost never get in the money for big losses. But this time it didn’t work- a fairly small downturn created huge losses and extreme increases in margin requirements.

Many seasoned traders I know saw their accounts reduced by 30-50% overnight with their brokers liquidating positions to satisfy margin requirements. In short, the debit side of this trade didn’t provide the promised protection during this event. Many traders, including me, saw big losses even though the debit spread didn’t even go in the money and the short puts were still well out of the money. It was the implied volatility that did the positions in, not the actual underlying market indexes.

Personal Impact

My experiences were mixed during this episode, but in all cases very eye-opening. I’ve done a lot of modelling of option pricing based on historical moves, the speed of moves, and other factors, and felt like I had a pretty good understanding of how volatility changes, even in big market moves. I survived the Covid crash, for goodness sake.

In most of my accounts, I had sufficient cash or cash equivalents to prevent a major problem with my account. However, I had one account that had two contracts of 112 positions that were using 90% of the account’s buying power before the big August 5 event (a bad idea in so many ways), and that account suffered a huge loss and was liquidated by my broker. I suffered a 250% loss, going from +$11,000 to -$17,000 overnight, which isn’t a small loss for anyone. My broker sold all of my short positions at the very bottom, in the early morning hours before the market even opened, locking in the losses, and then left the long spread positions to decrease in value as the market recovered, not allowing me to trade anything, due to having negative buying power in the account. It was a very helpless feeling to watch and see that much money evaporate. And then I got the email asking me to add money to get the account out of the hole. I asked why they had waited so long to close the positions, and why they didn’t wait any longer, but it isn’t the broker’s fault for this. It’s my problem and I have to own it. I simply got complacent and didn’t follow any of my own rules for capital allocation. I was greedy and I got burned- bad.

I wasn’t the only one, and in the aftermath, I read several option trader’s notes (that actually sell their trading advice) that lost years of profit during this event.

For all my other accounts that survived, the swings in value in accounts that had short options trading with margin was troubling and surprising. The fact that the values recovered as fast as they declined doesn’t change the fact that this could have been much worse and there are many lessons to learn.

For most stock investors, or even traders that sell option spreads or covered options, this event was no big deal. It was a problem for mainly for traders who sold naked options on margin, and especially for those that sold naked futures options on SPAN margin.

So, what actually happened, and why were so many option traders caught unprepared? Let’s dig into what happened, and then discuss how to avoid this kind of negative impact in the future.

The Perfect Storm of Fear

Markets were cruising to new highs in mid-July when it seemed that the market realized that maybe it was the time of year to finally step back and the market came down a bit. It was no big deal until August when the July jobs report came out on Friday August 2, showing very weak jobs data and an unexpected increase in unemployment. The market fell 1.8% during the day and there was a sense that the nation’s economy might be in trouble. Then over the weekend, foreign markets reacted, primarily in Japan, where the yen surged in value compared to the dollar, and many “safe” currency trades quickly unraveled. The Japenese stock market plunged over 12% in early trading, and the rest of the world followed along as other markets opened for Monday trading. With US Futures trading open, prices of all the indexes started down. Everyone trading wanted to get out, but there was no one available to bail them out. Futures options were the worst, with enormous bid-ask spreads with no one willing to make the market flow in orderly fashion. It was still the middle of the night.

Option traders awoke to alerts and margin calls from brokers. With an hour to go before the markets opened, buyers stepped in and started grabbing the bargain prices that were available, and selling short options for the astronomical prices that contracts were marked at, as brokers liquidated the unfortunate accounts of those who hadn’t cleared their negative balances. For those with cash, it was the opportunity of a lifetime. For those in trouble, some lost life savings over night. The best and worst of times.

When the market opened, it was down 3% from Friday’s close, but up from the worst levels of the night. It recovered about a percent in the morning but closed near where it opened. However, there was a sense that the worst had come and gone. Option prices quickly came back into somewhat normal ranges, and margin requirements relaxed. As the week progressed the market slowly eased up, day by day. By the end of the week, the market was essentially unchanged from the end of the previous week. Did anything really happen, or was it a dream? For almost everyone invested in the market, this situation was a non-event, a slight downturn, a bit of noise. But for Futures options traders that had naked positions, this was a never-to-forget nightmare.

By mid-August, it appeared that all the worries were for nothing. The US market moved back to near the record high levels set in July. Happy days were here again. But this isn’t normal.

Unprecedented Changes in Implied Volatility

In the past, increases in Implied Volatility have taken much bigger declines in the market for this big of a change. For example, during Covid, the market was down over 30% and the VIX volatility index hit 80 at the bottom after several weeks of large daily declines. The whole world’s economy came to a grinding halt and the market slid with it. At the time it was one of the most terrifying situations the world had seen.

In contrast, at the market’s lowest point on the morning of Monday, August 5, the S&P 500 futures were trading about 10% below the peak they hit in mid-July, and VIX sky-rocketed to 65. It was at less than 30 the Friday before. This rapid expansion in Implied Volatility over such a small timeframe and relatively small index price drop was unprecedented. Option prices multiplied in value and SPAN margin requirements for futures options increased exponentially. Brokers reached out in the middle of the night asking customers to add capital to their accounts, but from where, and how? Since the markets were closed, only minimal amounts of trading was going on and markets froze up with orders becoming unfillable. Trapped traders couldn’t get out, assuming they were even awake and aware of what was going on.

Likewise, the decrease in the VIX volatility index over the next few weeks was also remarkable. By August 16, the VIX index was below 15. Historically, large increases in volatility take months or even years to return to low levels, so this spike from levels of around 12 in early July to over 60 a month later, then back to 15 in less than two weeks is different than anything ever seen before.

For those not familiar, the VIX index is calculated by the CBOE to measure the volatility implied by options on the SPX index with expirations around 30 days away. The VIX index is not tradeable directly, but there are tradeable options, as well as futures that can be bought and sold. VIX is often considered the market’s “fear gauge,” but technically it is an evaluation of how richly options are priced. Since options are priced based on known values, with the only unknown value being volatility, this measure of “implied” volatility impacts all option prices. The numerical value of Implied Volatility of any option is a measure of how much the market expects the underlying security or index to move over the next year, but pro-rated down to the amount for the time left until option expiration.

Margin impacts

Margin works in a lot of ways with options. See the article on margin to learn more. But margin as true leverage is most apparent when selling naked options. For naked short options on stock, ETFs, or Indexes, most margin requirements are based roughly on having 20% of the notional value of the underlying in the account to cover a big move. So, one option contract on a stock trading at $100 would have a notional value of $10,000 and a seller of a naked option would be required to have $2000 for every contract, or would use $2000 of buying power or capital for each contract. If the stock moved 5%, the margin would likely require another 5% of the notional value, which could be as much or more than the premium collected.

If a trader is selling naked options on futures, a different margin calculation comes into play, SPAN margin. SPAN margin is a complex formula, but basically looks at the futures options positions and calculates a worst-case one day move, based on the IV of each option and other factors. This is typically a much lower requirement than what is required for options on stocks and ETFs, so a trader can have a lot more leverage. However, this works both ways. When the market moves, additional margin can be required based on the amount of the move, plus the amount that the “worst case” increased to. On August 5, when VIX spiked to over 60, the worst case scenarios as calculated by the SPAN margin calculation exploded by huge amounts, in addition to losses in holdings that were highly leveraged. As VIX virtually tripled, buying power requirements for futures options also went up by triple or more, when accounting for losses on top of the increased SPAN margin requirements.

Many traders in turn faced margin calls from brokers, asking them to get buying power from negative values to positive. For some the only way to do this was to buy back badly losing positions at big losses at terrible prices with terrible spreads. As much as anything, margin requirements drove liquidation as much as price movement.

The lesson on margin with options from this event is to always have cash or cash equivalent positions that can be easily liquidated to have cash to cover all margin requirements. Even a trader with the worst naked option exposure positions would be alright if their account was 80-90% cash. For me, I had accounts that I had to sell short term bond ETFs to cover buying power requirements on August 5. Every account but one was fine.

Within a few hours of the worst of August 5, VIX dropped significantly, and SPAN margin requirements reduced as well. The question was a matter of whether each trader had enough capital to weather the storm.

Marked loss impacts

When implied volatility spikes, Vega raises the price of options. On a percentage basis, the impact is greater for strikes further out of the money. For the 112 trade, the “1-1” portion of the trade that includes a 50 point wide debit spread has both strikes increase in price, fairly close to the same amount, while the two far out of the money strikes also rise substantially, but with nothing to cancel out their rise. The overall impact is that the total premium can grow much more than even the percentage increase in Implied Volatility. This is especially true if the positions were opened during a period of very low IV.

So, for a trader that opened a 112 trade when IV was down around 12-13 VIX, the explosion to a VIX of over 60 made the position’s premium value explode to 10-20 times what was collected, something that most traders would never have expected.

Position size considerations and notional value

With the 112 trade on /ES futures, a trader can use as little as $5000 buying power to control $500,000 of notional value. Even at very low Delta values for the 2 short strikes, it doesn’t take a very big move down to lose way more than the initial buying power. As we’ve just discussed, a big move causes two immediate problems for the trader, a marked loss as premium explodes, and an explosion of buying power requirements.

What is the solution? Keep trades like these a small portion of an account. The vast majority of the time, these trades just decay, leaving the seller with great profits, but when that rare occasion occurs, there needs to be plenty of capital in an account to cover losses and have the ability to manage the position.

Impact of the number of net naked options

I’ve tended to trade mostly covered positions and spreads, where this kind of scenario can’t happen because risk is defined, and a position can’t lose more than the buying power it requires. But it is easy to be persuaded by the siren call of those that tell traders to put on their big boy pants and sell naked options. Somehow, this is considered by some to be the mark of a mature option trader.

Often, traders are told that the buying power required is a good indicator of the risk of a trade. I’ve seen dozens of studies that make this claim. But typically, if you look at the fine print, these studies will say something like naked trades don’t lose more than their buying power 99.5% of the time, or some other high percentage. The problem is that the percentage is not 100%, and that little percent will surface on rare occasions, usually when least expected, immediately after a period of very calm markets.

The key isn’t to completely avoid naked trades, it is to manage the number of naked contracts being traded. During the August 5 event, 112 traders were much more impacted than 111 traders. The difference was two naked puts instead of one. Does that mean traders can load up on 111 and be fine? No, it just means that comparing two trades that both use naked options needs to account for the number of contracts that are naked and the difference in notional value and tail risk. Maybe the 112 trade has a slightly better return on capital typically than the 111. Is the additional risk worth it?

And it isn’t just the naked portion of multi-leg trades that need to be considered. Individual naked trades, as well as strangles or straddles sold naked can be even more susceptible to tail risk. There is a line of reasoning that diversifying will greatly reduce these risks, but in periods of uncertainty and big moves, prices fall across the board and implied volatility spikes everywhere.

Keeping the number of naked positions under control in an account may be the way to prevent a blow-up the next time the market melts down.

Defined risk vs. Naked Risk

If we compare risk of different types of option trading strategies, we can see that there is no risk-free way to trade options, and each risk level has a different set of risk parameters. Probably the closest comparison to selling naked options is to sell credit spreads.

Often, traders confuse the defined risk of credit spreads with being low-risk. In a credit spread, there is the very real risk of losing 100% of the buying power that was required or “defined” by the trade. However, during the August 5 event, the move didn’t impact most traders with out of the money put spreads, because both the long and short strikes of the trade went up significantly in value and if still out of the money, the net premium only went up a portion of the buying power as the moves mostly cancelled each other. Only when prices take an entire spread into the money are worst case scenarios in play. During the Covid crash where the market went down over 30%, this was the case for most spread traders. But on August 5, probably not.

Naked trades on the other hand have no hedge of a long option to provide any protection when the going gets tough. Naked traders are susceptible to both premium increase and buying power requirement increases at the same time when implied volatility spikes, even if the underlying price doesn’t move that far. This is the lesson for naked traders from August 5.

When the tide goes out, you find out who is swimming naked.

Warren Buffet has many famous quotes, and this is one of them. On August 5, 2024, if you were swimming naked with futures options in particular, or even naked options on margin in general, you were probably exposed. I’m not sure that this is exactly what Mr. Buffet meant by this saying, but in this case, a literal interpretation is very fitting.

One time event, or regular occurrence?

What happened on August 5, 2024 was a very unique set of circumstances that came together to create an unprecedented spike of implied volatility. Never before has VIX shot above 60 so quickly, and never before has VIX receded so quickly. So, is this rare event a once-in-a-lifetime occurrence, or will we see similar events on a regular basis?

I’m afraid that we are going to see this type of event many more times. We’ve seen global financial squeezes happen in the past, and this wasn’t even that crazy of a situation. The final straw that broke the proverbial camel’s back with this event was a liquidity crisis in Japan over a weekend. We’ve had other big banking fiascos around the world before and this one may not even be in the top 10 ugliest. What is different is the sheer amount of option positions that are in place now compared to only a few years ago. Today, it is normal for option volume to exceed the number of actual shares traded on major exchanges.

Why does the amount of option volume matter? While shareholders of stocks can simply hold through most downturns, option traders are often leveraged in fairly short duration positions that carry significant risk. When markets change, more traders need to purchase protection or need to get out of losing trades to stop their losses. If this happens when markets are closed, there isn’t much liquidity, and few sellers, so option prices go up, driving up implied volatility. With lots of people wanting to buy to get out or buy to protect, the lack of sellers can cause a panic. This is what we saw on the morning of August 5. Nothing has fundamentally changed since then, and option traders are continuing to grow in numbers.

My fear is that it will take less and less significant events to drive implied volatility and option prices to extreme levels going forward. So, if you weren’t impacted by VIX spike of August 5, consider this a warning shot across the bow. For some of us, they sunk our battleship. Don’t let it happen again.

Underlying Security vs Risk Permission

What level of option risk goes best with what type of underlying security? Depending on the option strategy, your choice of underlying security type can have a big impact on your outcomes.

What level of option risk goes best with what type of underlying security? Most people reading this might wonder what in the world is the point of this topic and why should I care? Depending on the option strategy, your choice of underlying security type can have a big impact on your outcomes. This might get a little deep, but hang with me and I think it will be worth your time.

4 risk levels, 4 underlying types

Brokers typical allow customers to trade options at four different levels of risk. I’ve written about how the risk compares between these levels. As a reminder the four levels are:

  • Level 0: Covered options- cash secured puts and covered calls
  • Level 1: Buy options
  • Level 2: Option spread trades- buy an option, sell an option
  • Level 3: Naked option selling

There are also four general types of underlying securities for trading options. With each comes different advantages and disadvantages. As a reminder the four types are:

  • Individual Stocks of Companies
  • Exchange Traded Funds (ETFs)
  • Index Options
  • Futures

For example, there are three different classes of underlying securities for trading options on the S&P 500 index: ETF options like SPY, Index options like $SPX, and Futures options like /ES.

So the question and point of this post is to examine which risk permission levels work best with which types of underlyings. It’s not an obvious question or an obvious answer. Most traders would say it doesn’t really matter- more risk is more risk, and less risk is less risk. But some underlyings are better built for certain strategies more than others. It doesn’t mean you can’t trade a strategy for a certain underlying, it is more of a question of what is optimal for the type of risk and potential return you are seeking in a trade.

The Matrix

I made a sixteen square matrix to evaluate each combination. I rated each pairing based on how well the option risk matched with the characteristics of the underlying. My conclusions are simply my opinions, and I welcome discussion and other opinions backed by data. So here is my matrix and what follows is the data and logic behind it.

underlying security vs option risk levels
Some types of option strategies and risk are better suited for certain underlying securities than others. With each combination is a brief explanation. Green choices are best.

Let’s review the boxes one row at a time, by risk level.

Covered Options

Covered or secured option strategies include covered calls, cash secured puts, covered strangles, and the wheel strategy. These strategies use the full value of underlying shares either in cash or shares to protect against loss from selling short options. The options being sold are much less volatile than the value of shares, so covered options are the only option choice that is a clear reduction in risk compared to owning shares outright. All versions of this option trading strategy limit upside growth while allowing the potential of losses to zero, but most of the time these strategies outperform owning stock outright. So how does this type of transaction impact different underlyings?

Individual stocks can be very volatile. Positive or negative news about earnings or products or lawsuits or mergers or management changes can make stocks move way outside their expected moves. These outsized moves happen more often than normal statistical distributions would predict. Even so, individual stocks tend to have options with much higher implied volatility than the overall market. For stock investors that want to dampen day to day moves of their portfolio balances, selling secured or covered options is a great way to participate in individual stocks with less drama. Because of the crazy volatility of individual stocks and the high implied volatility of options on individual stocks, covered options are a great match for individual stocks.

I would argue that for both the covered strategy and the stock underlying type, this is the strongest match in this row and column. There is no better underlying for covered options than individual stock, and there is no better option risk level for individual stock. I know a lot of people will disagree, but as we look at the other combinations, I hope you’ll at least understand my point of view.

Covered options on exchange traded funds are fine trades. It’s probably the safest possible option strategy there is if we want to call any kind of trading “safe.” We combine a bunch of volatile stocks together into a product that dampens volatility down substantially. Then we sell options against that new product that will rarely see moves outside the moves that are expected. The options may not pay a lot, but they won’t lose often either. A very boring way to make steady gains (and I’m thinking of boring as a good word here).

An argument could be made that covered options on ETFs is perfect for both, because it’s a double volatility reduction, and for risk-averse traders that’s a great combination. I get that, but for me, I think it’s a little too much volatility reduction, and sacrifices too much option premium for safety. Be less volatile with stocks by selling covered options, or be less volatile with riskier option strategies by using ETFs, not both. But I’m generally a risk taker, so maybe I under-appreciate the double volatility reduction of covered option strategies with ETFs.

Covered options on indexes is the easiest combination to rate on the matrix, because it is the one combination that can’t be done. We can’t own an index outright, so we can’t sell a covered call. If we sell a put and get assigned we don’t get the index, we just pay up the cash we lost. So, there isn’t a real way to sell covered index options on the underlying index. This is the only red square in the matrix because it can’t be done.

Covered options on futures can be done, but it doesn’t really make sense. Futures and futures options are all governed by span margin, so really there isn’t an official way to sell covered options on futures, because there is margin being used on every leg of the trade. No piece is fully “covered.”

I almost made the covered futures options block red, but you can kind of do it if you set aside the cash that the full notional value of the future is worth when you sell a call against a future, or sell a put on a futures contract. The problem is that your buying power won’t show that you’ve locked up the full notional value, so you have to track it yourself. It just isn’t what futures are about.

Let’s do a quick example to illustrate. Let’s say we have a futures product that trades for $1000 with a multiplier of 50. So the notional value of a contract is $50,000. If we buy a futures contract, the broker will use SPAN margin and only take away at most $10,000 of our buying power, even though we are on the hook for the full $50,000. If we sell a call on the same future, we’ll likely gain buying power, as we just reduced the volatility of the position. Maybe SPAN margin says we now only need $5,000 buying power, while we remain at risk for $50,000. So, our broker and SPAN margin don’t make us “cover” our options. You can keep $50,000 in your account to cover the trade yourself, but nothing forces you to, other than wanting to eliminate any risk of blowing up your account in a downturn. It’s fine to do this, but it technically isn’t a covered option, so it’s a yellow square on my matrix.

Buying options

When most people first learn about options, buying an option is the trade they can easily understand. You pay a premium to have the option to either buy or sell something. Margin is not a factor, because the risk is defined. The risk of the option is the cost, it can end up worthless, a total loss, but no more than what was paid to own the option. If the option ends up in the money, it may be profitable, maybe very profitable. Leverage comes from the possibility of virtually unlimited profit for a relatively low cost.

Buying puts or calls is like going to the security market casino. It’s a low probability bet that might pay off big, but often will lose what you gambled. But let’s not get all “judgy” against the strategy- lots of directional traders buy options to get the most out of a move they think will come. When implied volatility is low and the market is rolling up nice gains, it can be a very lucrative trade that exceeds its predicted probability. But which underlying security types are best fit to take advantage?

Individual stocks can make big moves up or down, and owning an option in the right direction when a big move happens can be great! But the market knows that individual stocks are prone to big moves so options are expensive to buy. A little move won’t cut it. A trader has to be very right on timing and direction.

But, if buying calls or puts is your thing, the biggest rewards are with individual stocks. So, I’ll give it a green square.

Buying options on ETFs is cheaper than stocks, but the likely moves won’t be as big. However, if the goal is to ride a trend that is going up faster than what implied volatility predicts or a slide going down, ETF long options are a good choice.

In a bull market, selling calls is usually a loser, which means that buying calls can be a winner. Buying calls on an ETF in a bull market will hit a lot of winners usually without a lot of capital required, so probably the best use of the strategy in this row.

Buying put and call index options is a very similar situation as options on ETFs. It’s really a matter of preference, depending on several factors. Some brokers restrict access to index options, so it might not even be a choice for some accounts. Most index options are bigger notional value, often 10 times as big as the equivalent ETF, so it might make more sense for a bigger account to use index options, while smaller accounts stick to ETFs. There are a lot more ETFs available than index options, so niche indexes either don’t have an index option or have such poor liquidity that the only choice is an ETF. Commissions per contract are often higher on index options, but per notional amount are lower. So, it depends on a lot of things. I’ve discussed the differences in much more detail in my write-up of different ways to trade the S&P 500. All the same trade-offs are true for the Nasdaq 100 and Russell 2000. So, for some traders buying options, the index option might be best so I’m coloring the combination green, but for most traders smaller, more liquid ETFs are going to be a better choice.

For futures options, the issues are similar as comparing index options to ETF options, except that buying futures options outright negates much of the advantages of futures options, but keeps the negatives. Futures options are a favorite of experienced and sophisticated traders because they can be traded with lower SPAN margin requirements, giving a trader more leverage, and also letting opposing positions reduce buying power. But, if a trader is only buying options, buying future options doesn’t gain much in buying power, but will cost a lot more in commissions and slippage from lesser liquidity than ETFs or index options. In my opinion the only time it makes sense to buy a futures option is to counter a bunch of short futures options or other futures position. I talked about this in my discussion of buying the 1 DTE straddle with futures options.

In the end, unless you have a really good reason to buy options on futures, it generally is a better trade to buy a similar ETF or index option product. So that’s why I colored this combination yellow.

Trading Option Spreads

Let’s define an option spread as buying and selling an equal number of puts or calls. There are a lot of ways to trade spreads, and many of my favorite strategies fall in this broad risk category. Option spreads have defined risk, but as strategies get more complex, understanding exactly how much risk a trade has defined can get a little tricky. It isn’t as obvious as the risk with buying an option, but the risk is known.

We can think of spreads in two main categories, debit and credit spreads. Debit spreads are trades where a trader pays to enter the trade, and credit spreads pay the trader to enter the trade. Credit spreads are often the highest leverage version of selling options, with the highest potential return on capital for many positions. With that potential high return on capital comes the risk of a total loss, often many times the amount that was collected to open the trade. How do these factors impact different underlyings?

With individual stocks having more likelihood of an outsized move, there is a bigger chance of a total loss on a credit spread, although that is somewhat balanced by higher premium from higher implied volatility. Debit spreads tend to limit max gain in exchange for improved probabilities compared to buying options outright. So, debit spreads on a individual stock miss out on big gains without a outsized increase in probability of profit.

Many traders favor spreads for individual stocks over naked options because of the defined risk limiting losses to a defined amount. My view is that both strategies have to contend with outsized moves and it’s a matter of picking which poison does the least damage. But because so many like spreads as a risk reduction for individual stock options and it is a viable strategy, I’ll rate this combination a yellow.

I’m going to lump ETF options and index options together for spreads. Just like with the earlier discussion on buying options, the difference between ETFs and indexes is a matter of preference and an individual’s account situations. Strategically, I like both for buying and selling spreads. Because ETFs and indexes are made up of many stocks, they have much fewer out-sized moves than individual stocks. This makes the leverage of spread trading work well, both in credit and debit type spreads.

In particular, selling put spreads on ETFs and indexes can be a high probability trade. I’ve written about this my page on selling put spreads. I’ve also written about the best delta for put spreads, and the best deltas for rolling put spreads. And in each case, I tend to stick to some version of a put spread on the S&P 500. I’ll add a call spread to turn the trade into an Iron Condor, which I’ve discussed in my post on rolling Iron Condors.

As for buying spreads, I’ll occasionally buy a call spread when the market is particularly bullish and Implied Volatility is low. Buying options in any style is usually a low probability trade, but there are ways to improve odds, and using a spread to have decay on the short leg off-setting the decay being lost on the long leg can be a big help. We can get more exotic with diagonal trades selling a nearer term option while buying a longer term option and actually having positive Theta for our trouble. In all these trades I like ETFs and indexes because the results tend to be more consistent.

Many of the ratio type trades that I do utilize two sets of spreads, like the popular broken wing butterfly trade. Again, I like ETFs and indexes because outsized moves are less likely than individual stocks.

You may be sensing a theme. Less outsized moves make using the highly leveraged option spread on ETFs and indexes my favorite choice for spread trades. It’s green squares for both, and my favorite use of ETFs and indexes, as well as my favorite way to trade spreads.

In theory, futures option trades with spreads should also be as favorable as ETFs and indexes. They work about the same and have the same type of probabilities. But there are two things that I don’t like about trading spreads on futures. One is a personal nit-picky concern, and one is a concern that virtually any trader would have.

Let’s start with the most legitimate concern. Futures options are less liquid than ETF and index options. They have wider bid-ask spreads, and they are harder to fill close to the mid price between the bid and ask. In many trades, the tick size, or the amount you can adjust your limit price by is substantially bigger than for the same trade on an index option on the same thing. For example, on $SPX index, we can adjust our limit orders by 5 cents up or down, but with /ES futures, we have to adjust our order in increments of 25 cents. To make it worse, often the volumes are much lower and even giving up 25 cents won’t get an order filled. So, it can cost a lot to get filled, and we haven’t even talked about commissions, which are generally also higher, both per contract, and even more so as percentage of the notional value of the position. Maybe someday these costs will get lower and it won’t bother me as much, but I just don’t like it for spreads with futures options.

But what about SPAN margin you might ask? Doesn’t that extra margin make it palatable to pay a little more so you can get that super-duper leverage for traders that like more risk and more reward? Well, this is my nit-picky problem with spreads on futures. SPAN margin isn’t that much extra buying power for spreads with futures options compared to indexes, ETFs, and individual stocks. Because spreads have defined risk, the two sides of the trade already have formed a hedge and SPAN margin doesn’t give much more buying power than the reduction from calculating the max loss of the total spread being wiped out. To be fair, futures traders get some additional buying power, but it isn’t enough for me to justify the higher costs of trading spreads with futures options.

I know there are traders out there that like futures with spreads that little extra buying power that comes from SPAN margin, but for me it makes more sense to go with an index option or ETF option where my risk is defined and doesn’t change. So, I’m giving this spot on the matrix a yellow. Proceed with caution.

Selling Naked Options

Selling naked options is supposed to be the riskiest of the whole bunch of risky option trades. In one way it is in that maximum losses are essentially undefined, but even with margin, the leverage of Theta or Delta as a percentage of buying power is often less than what happens with spreads. So, as long as we avoid outsized moves (which we can’t, by the way) there’s a strong argument that selling naked options is not nearly as risky as it would seem at first glance.

Let’s be clear about what selling a naked option is about. With covered options, we can sell a call or a put and there is either cash or shares covering the short option positions. For naked trades, the broker lets us sell on margin. Often we are only required to have something like 20% of the notional value set aside for covering the option sale. That’s great for our account as long as the price doesn’t move against us more than that 20%. Actually, the broker will increase buying power requirements as price moves against a position, so the requirements are always in flux. But with plenty of extra cash as a buffer and markets not going crazy, it’s manageable.

So, we are selling options on margin. What underlying type does this work best with? Let’s check out our four choices.

Individual stocks are the most likely underlying to have an outsized move, so they are the most likely to get a naked option trade into trouble. It doesn’t take much, a change at CEO, a merger or acquisition, surprising earnings announcements, good or bad product news- any of these can trigger a move way beyond the expected move. With individual stocks, the probability of an outsized move both up or down tends to be greater that what Delta would predict, or it often just isn’t that great compared to the other products with diversified components.

That’s my reason for avoiding naked options on individual stocks. I know lots of people trade naked options on stocks all the time, diversifying their holdings to reduce overall risk. But for me, why not use an underlying that is already diversified? I know individual stocks have higher Implied Volatility to pay a seller to take on that added tail risk, but for me it just isn’t enough. I’ve seen too many situations where a trader has gotten a very nasty surprise and lost way more than they thought they could. It can happen with any naked trade, but it’s more likely with individual stock options. So, for me this is a yellow box- proceed with extreme caution.

Now, let’s not try to make the argument that naked options on the other types of underlyings are super safe. They aren’t, and you can lose big. Ask anyone who had naked puts on the S&P 500 (any version) when Covid hit in 2020. It was bad. But those kinds of moves happen much less often than negative moves in individual stocks. People that trade naked options take a lot of risk, and so the question for the remaining three underlying types isn’t which one is least risky, but which gives you the biggest bang for the buck? If you are selling naked options, you better know what the risk is, but how do you maximize return when you have a trade go your way?

Like the last two levels of risk, ETFs and index options have essentially the same pros and cons for naked options. While there is significant tail risk, it isn’t as high as individual stocks. So, naked options sales on ETFs and indexes tend to perform better than the expected move would predict. This makes these underlyings a better choice for underlyings on naked options. As a result, I’m giving these matrix squares a green rating.

Finally, we have selling naked futures options. On one hand this is a highly leveraged trade with ultimate tail risk due to SPAN margining. On the other hand, this combination gives a trader the potential for significant high returns on high probability trades that otherwise might not make sense.

I look at naked futures options as the ultimate “go big or go home” trade. If a trader wants to trade futures options, selling naked gives the ultimate amount of exposure for the least buying power. SPAN margin allows a trader to use a fairly small amount of capital to open a naked trade. And if a trader balances the Delta of both sides of a trade, buying power requirements become even less, as the total risk is considered in required capital.

SPAN margin also lets a trader have different sides of the trade be at different expirations and have the net exposure of each side be considered in the SPAN margin calculation. The point is that for the most agressive, risk-tolerant option trader, there is no higher leverage way to sell options than selling naked options on futures. For that reason, I really like futures for naked options.

Selling futures options naked still have the issue of poor liquidity and higher commissions, but the flexibility of SPAN margin finally makes it worth the cost for risk-tolerant traders. It is worth noting that the liquidity and commissions are significantly more of an issue for traders that trade “micro” versions of futures options, like /MES, compared to /ES. Whether it is a futures product on an stock index, a commodity, or a currency, the micro versions just have a lot less open interest and liquidity. So, if account size limits trades to micro futures, a trader has to watch which expirations and strikes can be entered and exited without huge price slippage, particularly when exiting early.

Despite the cost issues with futures options, selling naked futures is my favorite use of futures options, and my favorite way to sell options naked. I give it a green box on the matrix. I don’t rate it this way to suggest it is a safe trade, but that it is the ultimate use of options leverage.

Bonus sections

There are a few option strategies that don’t fit neatly into the four categories of risk that I think deserve a special mention because I talk about them in other parts of the site.

Bonus #1 Ratio Style Trades

Ratio style trades are a more complicated type of strategy where there is an unbalanced number of contracts sold vs bought- a lot of times a 2:1 ratio in some variation. If there are more contracts sold than bought, the trade becomes a level 3 naked trade, like the 1:1:1 or 1:1:2 put ratio trade that I discussed in other pages. But often, I use a level 2 defined risk version of the trade by adding long options to equal out the short options, usually creating a wide credit spread along with a narrow debit spread, like a broken wing butterfly (1:2:1), broken wing put condor (1:1:1:1), or 1:1:2:2 put ratio.

These trades are technically either a group of spreads (level 2), or a spread with a naked short option (level 3), but is there a difference in what underlyings are best for these kinds of trades because of the ratios and odd ways of managing these types of trades? The short answer is not really.

For level 2 defined risk ratio trades like butterflies, condors, and 1:1:2:2 trades, I like ETF and index options for their liquidity and reduced volatility. This is the same logic as with spread trades in general.

For level 3 naked versions of ratio trades where there are more short options than long, my preferred underlying is futures options due to the reduced buying power of SPAN margin. These trades tend to be fairly highly probability of profit, but with significant tail risk from black swan type events. SPAN margin considers this risk and allows a trader to use a fairly small amount of capital to enter this kind of trade. Anyone trading this way must consider the significant tail risk into their management strategy.

A trader can use ETF or index options for these naked ratio trades, but they consume a lot of capital with standard option margining. Traders with portfolio margin accounts might find this more acceptable. For understanding of different types of margin in options, see my post on the topic.

Bonus #2: 0 DTE trades

0 DTE trades have special considerations because of their short time frame. Let’s throw in 1 DTE and any options trade that has just a few days until expiration. All these trades focus on either last minute moves or the extreme decay that comes in the final days or hours of an option contract.

Individual stock options don’t have daily expirations, so expiration day trades are usually limited to Fridays or end of month at most. That essentially eliminates them as a candidate, but it gets worse.

With options near expiration, assignment at expiration or near expiration is a big concern. Individual stock options and ETFs in the money can be unexpectedly assigned into shares in the days before the options expire. And if options are held to the end of the expiration day, assignment can happen even if the market closes with options out of the money. A late after the market news event could trigger option holders to exercise their options on individual and ETF options, so you never know.

So, that leaves index and futures options. Index options are settled to cash at the market close. Futures options expire into futures contracts at the market close. A trader doesn’t have to worry about after market events impacting an expired position. The only exception to this is monthly index options that settle on the open of the market, but stop trading at the market close of the previous day. These contracts have AM expiration, where almost all other options expire in the PM, at the market close. The ticker symbols for index options expiring and settling at the market close generally end with a “W” for weekly, which originally was for the weekly expirations that happened every week, but now happen every day. The monthly options, which are the very original index options, don’t have a “W” at the end of their ticker indication.

Settling to cash vs settling to futures contracts or shares is a big difference. Most expiration day traders don’t want to deal with the underlying securities ending up in their account and the significant notional value that comes with them. Because of that, index options are far better choices for trades approaching expiration.

Traders with small accounts can choose between micro index options, like $XSP, micro futures options like /MES, or ETFs like SPY. They have different pros and cons. Micro index options have fairly poor liquidity with wide bid/ask spreads and big tick sizes for poor fills, but settle to cash at expiration. Micro futures options have worse liquidity and bid/ask spreads, plus high commissions, and settle to futures contracts, all negatives, but are usually half the notional size of the other two low capital choices. ETF options tend to have good liquidity, but settle to shares at expiration, or after expiration. None of these are ideal, but if a trader wants a small option stake on expiration day, these are the choices to consider.

Conclusion

So, there you have it. A fairly exhaustive analysis of the various combinations of trade types vs underlying security types. Some of the factors I consider most important in this analysis, may be less important to other traders, and some accounts at certain brokers may not even give a trader a choice to have some of these types of underlyings available. Others may not have some risk permissions available.

In any case, my hope is that whatever level of risk or underlyings a trader has available, it is clear what combinations make might more sense from a viewpoint of risk, potential reward, capital usage, and trading costs.

0 DTE Option Trading

Many people are buying and selling options with zero days to expiration (0 DTE in option lingo). But is this a good idea? Are there strategies that actually work? Or is this just gambling? Well, like many things in options, it depends. There are strategies that have been successful with years of history, and we’ll dig in to discuss them.

In 2022, the option exchanges rolled out options on a few indexes that expire every day of the trading week. This has caused a frenzy of option trading by individuals who are trading a variety of expiration day strategies every day. Many people are buying and selling options with zero days to expiration (0 DTE in option lingo). But is this a good idea? Are there strategies that actually work? Or is this just gambling? Well, like many things in options, it depends. There are strategies that have been successful with years of history, and we’ll dig in to discuss them.

Over the past several years, the frequency of option expirations has increased dramatically, particularly for the major indexes, the S&P 500, the Nasdaq 100, and the Russell 2000. Initially, there were only monthly expirations that expired on the third Friday of the month. Options expiring every Friday were added several years ago, and Monday and Wednesday were added a few years back, and finally in 2022, Tuesday and Thursday expirations were added. Trading volume has grown exponentially, and trading on options expiring within the next few days are now the majority of option trades. Clearly, expiration day trading is very popular.

I’ve been exploring trading strategies for expiration day for several years, going back to when we started having expirations available for Monday, Wednesday, and Friday. I’ve discovered that 0 DTE is not for everyone, can have many elements of gambling for many, but has a few strategies that have a positive expectancy of profit.

Things to know about 0 DTE

First off, 0 DTE requires a different mindset than longer duration trading. Profits and losses explode in minutes, making the importance of having a plan critical. Options in general require strategies and planning, but 0 DTE is significantly more volatile. So, for traders that can’t handle huge swings in value over very short periods, 0 DTE may not be a good place to go.

For traders that do trade 0 DTE, I highly recommend keeping a log of all trades to be able to evaluate whether the strategy being used is actually working. Some trades have fairly high win rates, but have big losses when they lose- a log will help a trader determine if the wins outweigh the losses over the long run. Also, keeping note of what went well and what went wrong will help a trader learn from success and failure. I can tell you that most traders that fail do so by not sticking to their own rules for managing risk.

One key consideration is the Pattern Day Trade Rule that applies to accounts with less than $25,000. Federal regulations prevent small accounts from opening and closing the same position the same day more than three times in any 7 day period. Doing so will place severe limits on the traders account. If you have an account with $25,000 or less, or even just slightly more, you need to be very aware of this rule and how it works before even thinking about 0 DTE trading or any short duration in and out trading strategies.

There are a number of ways to trade 0 DTE. Some traders try to get in and out, while others hold a trade to expiration at the close of the day. Some are net buyers of options, what I will call debit trades, while other are net sellers, or credit traders. I say “net” because many strategies involve trading spreads, buying one option and selling another, generally the more expensive being hedged, protected, or partially financed by the cheaper option.

When options are expiring at the end of the trading day, all the characteristics of options are sped up. From a data driven standpoint, there are three key Greeks to consider. The two most obvious are Theta and Gamma which essentially battle it out for the day. But Vega also plays a key role, as big moves spike up Implied Volatility and option’s premium, and calmness can sap premium almost as fast. With hours or even minutes until the options expire, the Greeks’ calculations stop meaning as much as the concepts behind them.

Options sellers are banking on Theta eating away the premium as the day progresses. If the option ends out of the money at the end of the day, it is worthless. On the other hand, Delta will end the day at either 100 or zero and is likely to swing huge amounts during the day, which is the measure of Gamma, the change of Delta. So option buyers are looking for options to get in the money and run way up in value.

Since we are talking about expiration, it is important to understand the implications, which vary depending on what underlying the option is based on. Remember, there are four types of underlying securities, and at expiration the differences really stand out when an option expires in the money. For stock and ETF options, in the money options are settled with shares, which may not be the best outcome for day trading. In addition, while expiration option trading ends at the closing bell, expired stock and ETF options can be exercised until midnight, so even options that end trading out of the money still might be exercised if market conditions change after hours from news or earnings impact. Index options are much more straightforward. Index options are cash settled based on the price of the index at the closing bell. Because of this, index options, like SPX, are generally the preferred trading vehicle for traders holding options through the closing bell. Futures options settle with futures contracts unless the futures contract is also expiring the same day. However, futures options are assigned based on the price at the closing bell, not any after hours moves, so a trader knows at the bell whether there will be an assignment or not. So switching between underlying types for 0 DTE trades in not a trivial decision.

As mentioned before, because 0 DTE trades can rapidly change in value, having a mechanical trading plan becomes critical for consistent success. Most traders that trade short/selling strategies use stop losses to keep losses from getting out of hand, and long/buying strategies use some type of trailing stops or rolls to protect winning positions and keep upside unlimited. There are a few trades where holding to expiration (no matter what happens) could be considered, but I think 0 DTE are best managed by active trading based on market action.

So let’s get to it. Let’s discuss some typical strategies, both from the long and short side, considering what it takes to be successful.

Selling options with 0 DTE

Most 0 DTE option sellers I know actually sell spreads to define risk. Selling naked options on expiration day simply requires too much capital and carries too much risk for the average trader. The width of the spread can vary based on the strategy or capital available to the trader, but wider spreads tend to decay faster than narrower spreads. These trades are expected to win a high probability of the time, but to avoid severe losses, stop losses are also critical parts of the strategy.

While there are many variations of these strategies- different times to enter and exit, trading one side or both sides (puts and/or calls), entering or exiting all at once or legging in based on the market, the core of the strategy is the same. Sellers want to sell at a relatively high premium and buy it back for less or even let it expire worthless. I’m going to focus in on two common strategies that I have had success with and 0 DTE trading friends have done successfully- a wide Iron Condor and an Iron Fly. For discussion, let’s assume that we are selling spreads directly on the S&P 500 Index, ticker symbol SPX.

0 DTE Iron Condor

Iron Condors on expiration day seem to perform best way out of the money, selling options with 10 Delta or less and buying 30 to 100 points further out of the money. Greek calculations for 0 DTE can be flaky and vary widely, so many traders are more comfortable choosing strikes based on the premium available. For example, a trader may sell the lowest put strike that sells for over $1.00 or maybe over $1.50, and buy the put that sells for under $0.75 or $0.50. For perspective, you can estimate the expected move at any time in the day by adding the premium of the at the money put and at the money call. Generally, these strikes are between 1.5 and 2 times the expected move for the put being sold and another half expected move further for the put being bought as a hedge. So, it’s highly likely that the strikes will expire worthless.

Similarly, we do the same thing on the call side, selling a call and buying a higher strike call for less. If we choose similar Delta values, the premium for each call will be less, but the difference in premium may actually be more if we have the same width wings. It is a matter of preference as to whether to try to collect as much on the call side as the put side.

The risk vs reward for this set-up is the net premium difference between what was sold and what was bought and the difference between strikes. For example, if we sell a put for $1.50 and buy a put at a strike price 40 points lower for $0.70, we are risking 40 to make 0.80. Then, if our calls were sold for $1.20 and bought for $0.40, we have another 0.80 on another 35 wide spread. So in total we have 1.60, but still only 40 risk because the options can’t expire in the money on both sides. Actually, because the options are for a multiplier of 100, we risk $4000 to make $160. So, if all goes well, we make a 4% return on the capital needed in one day. Some traders sell slightly closer strikes to try to collect more premium, and others sell for less to improve probabilities.

While probabilities are fairly high that the strikes will end up out of the money, we never know for sure, so we have to protect our capital. Most traders I know use a 2x stop loss on each side. They limit their loss to twice the premium they collected on each side. So, if a put was sold for $1.50, losses are limited to $3.00 by entering a stop loss on the short put at $4.50. While a stop can be entered for the price of the spread, it isn’t recommended because during the day prices can vary in weird ways and stops can trigger on spreads when the price hasn’t really moved much. I’ve read numerous posts of traders who were frustrated by a stop that was executed when there position was in no danger because of a rogue quote. If possible, it’s best to have the stop trigger based on the bid price of the option if your broker allows it- for the same reason- to avoid bad quotes triggering a stop.

It can be frustrating when a stop triggers just as the underlying price hits the high or low of the day and reverses. A trader looks at this and thinks, “Gee, if I wouldn’t have triggered the stop, my option would have expired worthless. I took a 2x loss when I could have had a gain.” Unfortunately, a trader never knows when the price will reverse and when it will keep going. The goal is to stop our loss at 2x and not let it get to 10x or 20x. We can recover from small losses, losing all the capital of a spread trade can be devastating.

The Iron Condor is a 4 legged trade, so if one leg is stopped out, we still have three legs. On the side where the stop occurred, the long position will have gained value, although not as much as the short strike lost. We can hold the long strike in the event that price keeps moving, making the long strike more valuable. However, since the strike is likely still well out of the money, it is likely to expire worthless and probably is best to be closed out soon after the short strike stop occurs.

When we are stopped out on one side, it is even more likely that the opposite side will expire worthless. However, there is a small possibility that price action could reverse and move far enough to stop out the other side as well. For that reason, some traders will close out one side if the net premium has decayed 80 or 90% of the way while there is still a lot of time left in the day. The choice is take risk off the table, or hold out for that highly probable last 0.25%. Again, it’s personal preference.

So, let’s look at the various potential outcomes of our $1.60 Iron Condor:
1. most likely (~70%) both sides expire worthless $1.60 profit
2. sometimes (~25%) one side is stopped out and the other expires worthless ($3.00 loss on short stop, $0.20 gain on long, $0.80 profit on other side) $2.00 loss
3. rarely (~5%) both sides stopped out, assume no net gains from long strikes so $6.00 loss ($3.00 each side)
Adding all the probabilities together, we get an average return of 0.33 profit, or $33 on our $4000 capital. That’s just under 1% per day.

Can some traders do better? Yes, there are lots of variations that some traders believe give them a better advantage. But lots of traders do worse. Why? Because managing trades while sticking to a plan isn’t easy for most traders.

How can the trade be varied? Some traders enter the trade at different times in the day. They may enter at market open and again a few hours into the day. They may open on just one side based on technical indicators predicting movement in a certain direction. They may add based on one side based on market movement. They may have plans to add new positions when an old one is stopped out. Which variations work and which ones don’t? The probabilities are essentially the same but can be tweaked by collecting a little more or less in each trade.

Some may wonder why we wouldn’t just look at stopping out the whole Iron Condor when it loses twice the premium collected instead of managing each side separately. While it could be done that way, the challenge is that each of the legs of the trade are very dynamic in their values and the relationship between them changes dramatically during the course of the day. If the trade is opened early in the day, it is likely that by the final hour of the day only one position will have any meaningful value. Also, managing puts and calls separately allows traders to add and take away positions on either side independent of how they treat the other side.

On an ideal day for this trade where the market doesn’t move much after the Iron Condor position is opened, all the legs will decay proportionately and have little value left by the afternoon period a few hours before expiration. This is because expectations of the remaining move for the day will decrease and the price distance that was 1.5 times the expected move will become 3 to 4 times the remaining expected move. Since the probabilities are exponentially smaller of being tested, the premiums simply evaporate. One doesn’t have to wait to the very end to see the result.

Other days Iron Condor traders may see the price creep around moving toward one of their short strikes. Big moves early in the day can quickly lead to executing a stop, but the nerve-wracking position is the one is close to stopping out all day as the price moves ever closer to a strike price but not close enough to trigger a stop. For some traders this is stressful, for others fascinating. To avoid stress, many traders set their stops and go on about their day knowing that the market will decide whether the trade wins or loses.

Iron Fly 0 DTE trades

A completely different approach to capturing decay on expiration day is selling an Iron Butterfly or Iron Fly as it is more commonly called. The Iron Fly is created by selling an at the money call and an at the money put and buying protective wings outside the expected move of the day. The trade simulates a straddle, but defines the risk as the width of the wings to keep buying power reasonable. Most traders try to open these trades soon after the market opens and get out fairly soon, taking advantage of early morning premium decay as the market settles in.

As discussed earlier, the at the money put and call premium imply an expected move for the remainder of the life of the option. How big the expectation is varies from day to day. For example, on days when the Federal Reserve announces interest rate policy, the expected move is much higher than other days. Other anticipated news events can also trigger uncertainty about pricing changes to expect later in the day, driving premium higher. Other days, little news is expected and low premiums reflect that. So setting up this trade requires a review of prices to pick wing strikes that are appropriate.

Generally, most traders look for Iron Fly wings that are 1.5 to 2 times the implied or expected move. For example, if the total premium of the at the money put and call is $30, one might choose to buy puts and calls $50 away from the money. These should be fairly cheap compared to the at the money strikes. The idea is that there isn’t much decay left, these long options are simply protection from a sudden outsized move. An alternative is to use a set price for one or both of the longs, like $1 for the long call and buying the equidistant long put, which may cost slightly more due to pricing skew.

The most common management strategy I’ve seen for this trade is to set a win target and an offsetting stop loss, and let the odds play out. Iron Fly sellers pick either a percentage target or a dollar target for profit and typically set the stop loss at twice the win target. For example, one trader may target a profit of 5% of the premium, while another may target $1.50 profit every day. There’s logic for either approach, big values may hold value until the news event that is expected to move price, while low values may decay slowly. The key is that the bigger the target, the longer a trader is in the trade.

Why not go for it all and let the position expire? First of all, one short strike will definitely be in the money at expiration while the other short strike will be worthless. The day to day variation in results would be huge, perhaps making 50% return one day and losing 140% the next day. In addition, most studies I’ve seen on this approach suggest that this is a net losing trade over time.

The idea of getting in and getting out is that there are periods of time during the day, primarily at the open, when the level of uncertainty drops significantly in a matter of minutes or a few hours. Even with price movement, expected moves drop faster and the premium of the Iron Fly decays for a win.

In practice, the Iron Fly can tolerate a move of a few strikes up or down initially without stopping out. Early in the day the market often moves around searching for a price to stabilize on. The Iron Fly seller expects that movement to be small enough most days that a stop isn’t triggered and the settling price is close enough to the price where the trade started that the profit target can be achieved.

Setting a stop order or profit limit order is trickier with an Iron Fly than with the Iron Condor. The issue is that with the Iron Fly, a price move of the underlying generally impacts three of the four legs. One short goes into the money and the long on that side starts increasing in value, while the other short starts decreasing in value. The long on the untested side goes from low value to nearly worthless and isn’t a factor. A set and forget stop strategy would be to set a stop for the whole four legs, but triggers and fills can be inconsistent. Another approach is to watch the direction of price and set a stop for the three legs that are most impacted. Another is to set a mental stop and manually close if the price goes beyond your mental stop.

For example, let’s say we open an Iron Fly for $30 credit and target $1.50 profit. We can enter a limit buy to close order to buy the whole position back for $28.50. We could alternatively place a stop loss order at $33. Some brokers allow a bracket order that combines the two orders into one for a situation like this. If we want to watch and mentally manage the order, we may choose to only close the three legs that have meaningful value.

Time in the trade can vary from minutes to hours. Some days the price sticks right where the Iron Fly was sold and the price decays in 5-10 minutes. Other days, the price may grind away varying premium between the profit and stop targets for hours. Many traders set a time limit- if the trade doesn’t hit a stop or profit target in 2 hours, close it and move on.

Time to enter is a bit of a personal preference as well. Some traders try to enter within seconds of the market open when there is the absolute most premium available. Others wait five to fifteen minutes for the initial big move to stop. Some do just one of these trades a day, while others open several at different points in the day. Some avoid Federal Reserve days while others embrace them. There are advantages and disadvantages to each way of entering, but often it comes down to comfort of the trader with a chosen approach, the probabilities are similar.

Over time, the math is fairly simple with this trade. We need to win more than twice as often as we lose. The studies I’ve seen show this as a net winner. The other key is stay mechanical and respect identified stop values. Most people who fail at this trade do so by getting sloppy with their stops and hoping for prices to reverse while the loss multiplies. Discipline can’t be overstated.

Long Strategies for 0 DTE

Buying an option on expiration day requires a strategy that can overcome the rapid time decay of the option purchased. Since there are huge volumes being bought each day, there must be some validity to this approach.

Buy 0 DTE Straddle

One simple approach is to buy a straddle and hope for an outsized move. This is essentially the strategy discussed in the post on the 1 DTE Straddle I’ve written about separately, just done on expiration day. The difference is that at 1 DTE, there is overnight movement that may impact pricing, while once the 0 DTE trading day has started, we only have the day’s price movement to consider.

This strategy is essentially the opposite of the Iron Fly strategy and counts on movement of price to exceed time decay. Since risk is limited to the premium paid, there isn’t much value in selling wings, which would limit the upside of any move.

When would one open a 0 DTE straddle? Perhaps right at the open, looking to capture a big early morning move. Or just before a big announcement, like the Federal Reserve interest rate announcement or press conference. Or maybe at a point in the day where there is time left but the straddle is just very cheap and a small move will make it profitable.

The biggest challenge is deciding when to get out both for winning and losing positions. The position won’t expire worthless, so should there be a stop loss? When a position wins, when is the profit enough to justify the strategy over time? Since the trade has theoretical unlimited profit, shouldn’t we preserve that potential? Tough choices, so thinking through a plan ahead of time for the situation is critical.

My go-to plan is usually to roll in the money puts toward the current strike price when I can collect a significant percentage of the roll distance. Early in the day, I might roll my strikes $10 when I can collect $7. Later in the day I may do it if I can collect $8. The idea is to take some of my winnings off the table while allowing for additional movement to make more. I protect myself from a reversal wiping out my profit. I find this approach reduces the volatility of my win and loss amounts.

Jump on the Trend with a Long Option

Many traders like to use Technical Analysis to predict future movements of the market. They detect when a trend in one direction is starting and determine how long they expect it to last. A great way to take advantage is to buy a call when the market is trending up and sell it at the top before it has time to decay, or buy a put on a downtrend and sell it at the bottom.

Generally, the idea is to get in opportunistically and get out. Time is ticking against the option buyer on expiration day, so the buyer has to be right on direction and right on timing. If the trend is small or slow moving, premium will decay faster than the underlying price can increase it.

A typical strategy on an uptrend is to buy a call a few strikes out of the money. For SPX, this might cost $10 premium or $1000 for the contract. The Delta value might be 30, so that a $10 price move would net $300.

If the strike ends up in the money and is above 50 Delta, a roll to a higher strike should net at least half the distance of the roll. For example, one might roll up $10 for a $5 credit. Or wait to get further in the money where a roll up could net a higher percentage. Or just close the trade when technical analysis says that the move is approaching the top of the range.

The same basic strategy would work with puts on a downtrend. In either case, the market needs to move decidedly in the buyers favor for there to be a profit.

Time of day impacts premium pricing as well. Early in the day there is obviously more premium than late in the day. Buys earlier in the day can follow long all-day trends and make up for the high premium to get in. Late day buys can pay off quickly with a fairly small move in the direction of the trade. A trader has to be aware of the time left and manage accordingly.

The Binary Event

Often, the option premium and price movement of a day is greatly influenced by a single scheduled event. A piece of news, like an economic report, or a Federal Reserve rate announcement is often anticipated by the market with high option premium before the event and much lower premium after. These events are referred to as “binary,” in other words true or false, 1 or 0, good or bad. The impact of these events really have three outcomes for option traders- the market goes up, the market goes down, or the market basically doesn’t move. A trader doesn’t really know what the market will do, so how can we play one of these events.

A starting point might be to look at how much premium is elevated. Sometimes the market is expecting a big impact and sometimes a small one, and it often pays to be contrarian in regards to expected impact. How do we know if the premium is high or low? It takes only a few weeks of watching premium prices to grasp whether premium is higher or lower than normal, and if the high premium for a binary event is extra high, or actually a bargain. If premium is lower than normal, it might be a good time to buy options, either a straddle, or an out of the money call or put in the direction that the market is most susceptible to a big move. If premium is extra high, selling an Iron Fly or Iron Condor might make more sense.

Binary events tend to behave in crazy ways. When the initial news comes out the market may rocket in one direction for a few minutes and then reverse back to where it started or even switch from a big move in one direction to another. Most market observers explain this by noting that the very first reaction is from robot traders that look for certain numbers or words in a statement and interpret them as bullish or bearish, triggering large buys or sells. Then a combination of cooler heads prevail, as the market digests the information and puts things in context. After a while, the market decides whether to take the event as a positive, negative or neutral for the near-term future.

I know many traders avoid binary events because of the unpredictability of market behavior. There simply isn’t a built in probability advantage to any specific trade, and big losses are a distinct possibility. For traders that do like these trades, a plan for managing the trade is critical, when to get in, and a plan to hold, fold, or roll depending on the behavior of the market.

Conclusion

0 DTE trades are extremely popular now that they are available every trading day. However, that doesn’t mean that they are an easy way to make money. In many ways, they are the closest option trade to gambling that there is available. Gaining an edge requires developing and following a plan that accounts for both the potential movement of the market and decay of options. For traders that regularly trade 0 DTE options, it is critical to track all trades to make sure that the strategies used actually average a positive return over time.

I’m actually not a big fan of 0 DTE. For me it is too much drama with too little edge. The rest of this site is dedicated to other strategies that I prefer. But for traders that have the wits and discipline to trade 0 DTE, all I can say is “best wishes!”

Buy 1 DTE Straddle

I buy a 1 DTE straddle on indexes for two reasons. 1, It has a positive expectancy over time. 2. It is a hedge against short option positions

I’ve started buying 1 DTE straddles on the S&P 500 for two reasons. First, this straddle trade has a positive expectancy- over time it has made more than it has lost. Second, and perhaps more importantly, the straddle is a great hedge against my many short option positions further out in time. How I came to these observations and how I manage this trade are the topics of this discussion.

A straddle is buying a call and a put at the same strike price and same expiration. When traded at the money, it roughly represents the expected move of the underlying for that time period. So, buying a 1 DTE straddle for $30 would mean that the market expects the SPX index to move around $30 plus or minus the next day. Buying a straddle means the buyer is hoping the market will move more than expected, and the seller is hoping the market will move less than expected.

Normally, I only sell options or spreads for a net credit and wait for the value to decay away for a profit. I mostly sell options with expiration dates weeks or even months out and a decent distance out of the money. Those trades have a high probability of profit. However, they also carry the risk that an extended big move in the market could result in a big loss.

Profiting from the trade outright

With 2022 being a bear market year, I have studied more about ways to manage positions in downturns. One interesting book on the topic is “The Second Leg Down: Strategies for Profitting after a Market Sell-Off” by Hari P. Krishnan. One observation in the book is that options under 7 DTE tend to be undervalued and have good potential to make money or protect a portfolio in the midst of a downturn. The book has numerous interesting strategies to help navigate downturns. I’ve toyed with a few of these, but I couldn’t find a trade strategy that achieved the type of positive outcome I was looking for.

As I’ve noted elsewhere, I’m a big fan of the TastyLive.com broadcast site. Just before Christmas at the end of 2022, Jermal Chandler interviewed Dr. Russell Rhoads on his Engineering the Trade show. The topic was short duration options that are now quite prevalent. One key point is how very short duration at the money (ATM) straddles on SPX (S&P 500 Index) and NDX (Nasdaq 100 Index) are actually underpriced. If you buy a 1 DTE straddle at the end of the day and hold to expiration the next, it has averaged a positive return in the past year, which says these options are actually undervalued, counter to what we would normally expect.

I’ve added the presentation, which is broad ranging on the topic here:
(Press the red play button to watch)

Starting at about 8:00 into this video, the discussion starts on how 1 DTE premium has been underpriced for the past year.

I decided to try buying these as a one lot and so far I’m seeing this work out with a positive return. And this has been during a few mild weeks with little movement. The straddle never expires worthless as one side is always in the money- it’s just a matter of how much. I have generally closed these early, selling the side that is in the money when I can for more than I paid for the straddle. So far, this has worked better than holding to expiration because we have been range-bound. When we get into a trending market one way or the other, it will likely make more sense to hold.

The hedging benefit

However, I found a second benefit that may be much bigger. I decided to switch over and buy a 1 DTE /ES (S&P 500 mini futures) option straddle in an account with a lot of short futures options for a 1 DTE straddle- not sure why I even decided to other than the size is half as much. Anyway, I noticed that buying one straddle greatly increased my buying power by over $27K, which didn’t make sense initially because I was paying a debit and I thought that would reduce buying power by what I paid-about $1500 ($30 x 50 multiplier).

It turns out that the futures SPAN margin saw this as a big risk reduction. (For more on futures options and margin, see the webpage on different option underlyings.) Buying the /ES straddle gives me 500 equivalent shares of SPY notional in either direction of price movement. This will counter several short options out in time and out of the money. So essentially it is a shock absorber for my futures positions.

Many traders are nervous about the overnight risk of holding short options, due the possibility of a big gap in price overnight. Having a hedge like this can help mitigate that risk.

The biggest question is how big of a position is appropriate? Well, keep in mind that if the market doesn’t move at all and closes very close to the strikes of the straddle, the straddle will be nearly a complete loss. So the size of the trade should be a very small portion of a portfolio, as this trade will be very volatile, going from losing nearly 100% some days to returning several multiples of the initial value others. Think of it as a volatile side trade that can reduce volatility of a much larger set of positions. Kind of a contradiction.

Futures make this obvious, but the same logic applies to any portfolio full of short option premium. The S&P 500 and Nasdaq 100 indexes have a variety of options underlyings at different costs to allow traders of virtually all account sizes to utilize this kind of trading strategy.

So, I think there are a number of angles to pursue this from a trading and portfolio management tool. I thought it might make a good topic to discuss with this group- the gamma of this trade provides a lot of protection at a low cost, essentially free over time, although likely to have periods of loss.

Essentially, I look at it as a great hedge that can still make money on its own. If I have out of the money longer-dated short options in a portfolio, they will make money on calm days, and the 1 DTE straddle will make money on turbulent days. And if I manage each correctly, each should make money over time.

Managing the Straddle

I tend to buy these straddles right at the close the day before expiration. On Fridays, I buy Monday’s expiration, which surprisingly often is about the same price as other days. I’ve tried buying two days out and laddering, but that gets to be a lot to keep track of if I try to manage early, so I prefer to buy at the money at the close for just one day.

A 1 DTE straddle benefits from big moves on expiration day
Big moves by the end of the day can be very profitable for a 1 DTE straddle, so so can smaller moves overnight or early in the day that allow a trader to manage the trade or take some risk off the table.

Like all option trades, there’s always a management choice of hold, fold, or roll. This trade has all those elements to choose from.

As mentioned earlier, probably the simplest choice is to just hold to expiration. The odds are that over time, the trade will win more than lose. However, this may mean that we have a day where a trade is profitable at some point in the day, but then moves back toward the strike price and loses money. Finding a way to beat simple holding takes a lot of effort and since we know the worst case scenario is losing all the premium we paid, we may want to just let it ride. On days where the market is on the move, this can be very lucrative, as the max move may be at the close of the day. Think of holding as the default way to manage the long straddle.

I’ve found that calm days in a range-bound environment are ones where prices explore support and resistance levels before returning to a point closer the strike price. As the day goes on and price stays constrained, I look for a chance to sell one side of the straddle for a price more than I paid for the total. Earlier in the day, I feel like I can be greedy and wait for a big profit, but as the day goes on, I’m happy to get out for any profit. So, I’ll fold one side of the straddle for a profit when it doesn’t look like we are going to close at an extreme move. Occasionally, I might get to sell the other side if there is a late move in price to the other side of the strike price.

So, that’s hold and fold. How/why would I roll? Let’s say the market has moved a significant amount from the strike price, and I’d like to take a profit but still have the possibility of taking advantage of additional movement. I can roll my in the money option toward the current price for most of the distance rolled. For example, let’s say the price of SPX is down 40 points midway through the day and I’m worried it might come back up, but want to also benefit if it keeps going down. I could roll down my put 20 points and maybe collect $18, locking in 90% of the move. If the price keeps moving, I could keep rolling. The downside of this is that I don’t get 100% of the move, and I’m paying commissions on each roll, and these trades will be pattern day trades if I close the new position before the end of the day. I also will have a hard time locking into a profit that is beyond my purchase price, unless I have a really big move. But rolling is a choice to consider for some traders and some accounts.

Conclusion

So, there you have it. A volatile option buying strategy one day before expiration that averages a profit and can hedge other positions in a portfolio. I have found expiration trades stressful in the past, but this one has been much less stressful to me despite the volatile nature of it.

Visualizing the Expected Move

Understanding and charting expected moves based on implied volatility and option pricing can be a helpful tool for option traders.

The expected move is a concept that is important for option traders to understand and use. It took a while for me to grasp this when I started trading options, but now it is something I consider in trading on a regular basis. Expected move allows a trader to put into context what implied volatility and option prices are predicting for the future. While expected move isn’t a Greek, I’m including it in the group of Greeks because it is derived value from option prices and is closely related to some of the Greeks and the ways they are calculated.

Option prices increase and decrease with changes in implied volatility. Actually, since implied volatility is just an “implied” concept, Implied Volatility is the explanation of why option prices go and down after taking into account the other key pricing factors of time and price movement. Implied volatility is a percentage that represents the standard deviation of price movement for the next year, as implied by an option’s price. In any normally distributed data set, approximately 68% of the data will be within one standard deviation of the mean of the data. Stock prices aren’t typically normally distributed (they won’t perfectly fit in a bell curve), but for simplicity most people make the assumption that they are and understand the differences in outcomes to consider. I won’t dig any deeper down this hole, because for most purposes the statistics work pretty well for stocks and options, despite the simplifying assumptions that most traders make.

Options have the unique ability to express how the market in general expects prices to vary between the current time and option expiration. This is possible because the market of buyers and sellers settle on prices that balance risk and reward for future outcomes based on all currently available information. The result is that we can determine how much the market is expected to move in any timeframe, based on option prices. It is kind of like sports gamblers betting on the over/under of a game score- the betting line is determined by the cumulative expectations of those wagering based on what is known about the scoring and defensive ability of each team.

Ways to measure the expected move

One very quick way to determine how far the market is expecting the market to move by a given expiration is to add together the put and call premium of the option strike closest to the money. As I write this, the S&P 500 index (SPX) sits at 4108.54. The closest option strike is 4110. Looking 40 days out, the midpoint value of the 4110 call is 125.60, and the 4110 put is 123.15. Adding these together, we get 248.85. Why is this significant? Let’s say one trader buys these two options (a straddle) and another sells the two options. The break even is a move of plus or minus 248.85. Both the buyer and seller would feel like this is a fair trade. The market of buyers are hoping that the market moves more than expected, and the sellers are hoping it moves less. As a balance, it is a measure of the expected move.

Studies by TastyTrade.com show that this at the money straddle pricing often over estimates actual future moves slightly. For their TastyWorks.com trading platform, they use a modified formula that takes the at the money straddle and the first two out of the money strangle prices in a weighted average to calculate an expected move that historically is closer to the moves that actually end up happening. For the same timeframe, Tastyworks has an expected move of +/-263.83, so for some reason at the moment their calculation is slightly higher than the at the money straddle. Only a few trading platforms actually show an expected move calculation, and it is done differently at different brokers as there is no default standard.

How does this relate to implied volatility? Well, as it turns out the implied volatility multiplied times the price of the underlying stock can match fairly close to expected moves calculated by at the money straddles. The straddle or similar TastyWorks method come out to approximately a one standard deviation move. So a very quick calculation is to take implied volatility multiplied by underlying price multiplied by the square root of the fraction of a year until expiration. The square root part is a little much to begin with, but it is based in statistics and math. So, for our previous example, we will use the current VIX value for volatility of the S&P 500, which is currently 24.79. We have 40/365 of a year for 40 day move, and the square root of that fraction is 0.33. With the current SPX price still at 4108.54, we multiply by 24.79%, then by 0.33, and get 336.10. This would imply that the market is expecting something less than a one standard deviation move in the next 40 days. However, the calculated one standard deviation move is just 27% more than the TastyWorks expected move. For something that is “implied” from option prices and calculated in a couple of different ways, that actually is fairly close- close enough for us to have a ballpark estimate of what the market is likely to do in the future.

So, what is the best way to determine an expected move? Well, there is no right answer because no one really knows what the future holds. But, we know that more often than not, options are overpriced for the moves that eventually happen, so implied volatility will typically be more than realized volatility, so methods that show smaller expected moves will likely be closer over time. But to use the straddle method, a trader must have access to option tables for every expiration of interest and do calculation after calculation to see how the move evolves with time. Using the calculation of volatility and the square root of time allows a quick way to estimate moves over a broad range of time. For option sellers looking to “play it safe,” this calculation may encourage the choice of wider short strikes.

Charting Expected Moves

Once a trader understands the concept of the expected move, it often helps to see how this works out on a chart over time. Let’s look at a chart for early 2022 for SPX.

April 1 Expected Move
At the beginning of April 2022, we can see the expected moves for the next few months.

After a week we can see that the moves stayed inside the expected move. With another week of information, we can update our expected move chart.

As time passes, the expected move changes as well with new pricing information.

As it turned out, this period of time included a fairly strong bear move down that was outside the expected move for a while, but then returned inside.

expected move vs realized move
Using the original expected move, we can see how the realized move played out.

This example illustrates a point worth noting. The longer the time duration, the more likely that the realized move will stay within the expected move. Time allows probabilities to play out more.

Another factor with expected moves to consider is that implied volatility can vary significantly over time and those variations can dramatically impact expected moves of the future. Consider that an expected move when VIX is 30 will be twice as large as when VIX is 15. When implied volatility is high, the market is expecting big moves in the future. When IV is low, the market is expecting calm in the future. When the market gets volatile, it tends to take a lot of time to calm down. On the other hand, when markets are very calm, sudden changes can cause sudden spikes in implied volatility and future expected moves. It is far from an exact science, but it is the best real time future indicator of movement we have.

Regardless of how we calculate the expected move, it gives us a good idea of what the market currently collectively thinks the future movement of pricing will be. For planning option strategies, this can be very helpful.

Options on the S&P 500 Index

the S&P 500 index is very appealing but most traders don’t know there are at least 7 different great choices for options tied to the index

For many new options traders, trading the S&P 500 index is very appealing for a number of reasons. But most new traders are not aware that there are at least 7 different great choices for options tied to the index. Most have multiple expirations each week and are very liquid. Each choice has unique differences from the others that may make it appealing in certain circumstances. For a long time I was only aware of one way, and when I now tell others about these additional choices for options, it’s usually a pleasant surprise.

Background

The S&P 500 index is the most quoted benchmark of the stock market for good reason. It is made up of the 500 largest US publicly traded companies. The index is weighted by market capitalization of each firm, so the largest companies have more impact on the index than smaller ones. In fact, as of this writing, the seven largest firms are responsible for 30% of weight of the index. While the news media often leads market reports by sharing the Dow Jones Industrial Average, most traders and asset managers pay little to no attention to the Dow because it only includes 30 stocks and has a bizarre price weighted averaging system that gives the most weight to companies with the highest price per share.

If a trader can choose only one investment to own, some form of the S&P 500 index would be the most logical choice. When selling options, unexpected moves outside of expectations can lead to large losses. Many studies have shown that the S&P 500 index is much less likely to have an outsized move than individual stocks or even other indexes. TastyTrade has done numerous studies on this that are free to review. So options on the S&P 500 index can be a large part of a trader’s strategy. Understanding the variety of choices for trading options on the S&P 500 can be very helpful for traders of all experience levels.

Mutual Funds?

Almost every employee retirement account offers a mutual fund that mimics the S&P 500 index. While mutual funds are great for retirement accounts that rarely change holdings, they aren’t that useful for trading in general, and specifically not for options. There are literally dozens of mutual funds based on the S&P 500, but they share the same trading issues- they only trade at the closing price of the day which isn’t known until after a trade is submitted, and there aren’t options on any of them. Active traders want to be able to buy and sell at any point in the trading day and have options for hedging or amplifying returns, so mutual funds just won’t cut it.

Exchange Traded Funds

In recent years, exchange traded funds (ETFs) have grown in popularity. These funds are structured to match the holdings of underlying indexes or other trading strategies. The funds actually hold shares in the index that they are matching performance with. By far the largest ETF is the SPDR S&P 500 ETF Trust, which goes by ticker symbol SPY, and follows the S&P 500 index. It is priced at approximately 1/10 the price of the index per share. So, if the S&P 500 index is priced at 4500, the SPY ETF will be priced around 450. The SPY price isn’t exactly 1/10 of the S&P 500 index price, but slightly less by varying amounts. The variations are due to fees that come out of the ETF, and the impact of dividend payouts. SPY pays dividends once a quarter, and the price of SPY gets closer to 1/10 of the S&P 500 index as the dividend payment approaches and then drops after the dividend is allocated. Generally, the variation is less than one dollar in SPY, so if the S&P 500 index is trading 4500, SPY is likely to actually trade at somewhere between 449 and 449.50. For most traders, this difference isn’t a big deal, but just a minor factor to be aware of when comparing SPY to the S&P 500 index. Because of its name and ticker, SPY is often referred to as the “Spiders.”

SPY option contracts are based on 100 shares of SPY. If an option is exercised or assigned, the option seller will either be forced to buy or sell 100 shares of the SPY ETF. Because SPY pays a quarterly dividend, traders who sell calls on SPY need to be aware of the risk of having the call option exercised on dividend day. If a trader has a call near expiration that is at the money or in the money, it will likely be exercised because the dividend can be captured by the owner of the stock. If the call seller doesn’t have shares to be called away, and the option is executed, not only will the seller be short shares of SPY, but the seller will have to pay the dividend to the broker that they are borrowing the shares from. Only call sellers have to worry about this, but it is a real consideration four times a year.

Both SPY and options on SPY are extremely liquid with bid-ask spreads normally at one penny. I’ve found option trades that include four legs, can usually be filled immediately for two cents away from the mid price of the combined bid-ask spreads of all the legs. Options are priced in increments of one cent, so pricing can be fairly precise. SPY options have 3 expirations per week, with contracts for every Monday, Wednesday, and Friday. Adjustments are made for holidays when markets are closed. Every expiration has dozens of strikes, going several expected moves above and below the current price of SPY.

While SPY isn’t the only ETF to track the S&P 500 index, it is the predominant one, and really the only ETF to really consider for trying to match the performance of the actual index. There are a couple of other ETFs to consider that are designed to magnify or reverse the performance of the S&P 500 index. For some strategies, these might be helpful.

UPRO is an ETF from ProShares that is leveraged to deliver 3x the performance of the S&P 500 index. Officially, it is called the ProShares UltraPro S&P 500 ETF. So, if the S&P 500 index goes up 1% in a day, UPRO will go up 3%. However, the reverse is also true- if the S&P 500 index goes down 1% in a day, UPRO will go down 3%. To keep this relationship working, the holding in the ETF are adjusted each night, so over time the ETF won’t exactly keep pace at 3x the performance. The ETF relationship is more precise day by day than longer term, but will be relatively close to 3x. UPRO has options expiring every Friday and is somewhat liquid with wider bid-ask spreads than SPY. Because of large swings in price, the ETF has occasional splits to keep the share price reasonable, and the daily adjustment of holdings can alter the precision of the leverage factor, so the share price isn’t consistently convertible to a multiple of the S&P 500 index.

The opposite effect is achieved from the SDS, or Proshares Ultrashort S&P 500 ETF. SDS is set up to delivery -2x the performance of the S&P 500 index. So, if SPY goes up 1%, SDS goes down 2%. Over time the price of SDS tends to get lower and lower, and a reverse split is needed to get the price up to a reasonable level. Options on SDS also expire weekly. Both SDS and UPRO options are based on 100 shares of the corresponding ETF.

Options on leveraged ETFs are much more volatile than on non-leveraged ETFs. Because traders of these options know that there is multiple times price movement, options are priced accordingly. Because of this, strategies with options can perform very differently than with options based on the non-overaged SPY. The switch from SPY options to UPRO or SDS options is not as simple as it might appear, so research thoroughly before jumping in to these unique options.

There are other ETFs that follow the S&P 500 index as well as others that leverage the S&P 500, but they don’t trade with as much volume, and their options trade less frequently. Why trade a product that is less liquid, with fewer options, and much lower option volume when a better choice is available? I see no reason to use anything but SPY, UPRO, and SDS.

There are also ETFs that represent sectors or portions of the S&P 5oo, or weight the 500 stocks of the index equally. So, for value vs. growth, or Finance stocks or Utilities, there’s are ETFs with options of every flavor. But none of those represent trading the full S&P 500 index, so we won’t dig in any further into those products, because the point of this discussion is ways to trade the benchmark index.

For most traders, SPY options are the only options on the S&P 500 index they use, and many traders aren’t aware of any other choices for trading options on the index. But, we’ve only just begun.

Index Options

Why trade options on an ETF based on an index when you can simply trade options on the actual index? Index options remove the ETF from the mix and link options directly to the index. For the S&P 500, there are two index options available, SPX and XSP. SPX is literally the S&P 500 Index, and XSP is the Mini S&P 500 Index.

Traders are often not aware of these ticker symbols or the fact that options are available for these two indexes. There are a couple of reasons for this. There is no way to actually buy or sell the actual S&P 500 index directly, a trader can’t buy or sell shares of SPX. Additionally, since SPX is an index and not a stock or ETF, many brokerages don’t show it as SPX. For example, Schwab lists it as $SPX. Other sites may show it as ^SPX or .SPX. The point is that you have to know what you are looking for to even find it. Since SPX is literally the S&P 500 Index, it is priced at the full price of the index. So, if the S&P 500 Index is at 4500, SPX is at 4500. They are exactly the same.

Okay, SPX is the S&P 500 index. But, what is the Mini S&P 500 index, you may ask? XSP, or the Mini S&P 500 is simply an index that is 1/10 of the S&P 500. However, unlike SPY, which is approximately 1/10 of the S&P 500 index, XSP is exactly 1/10 of the S&P 500 index. Why do we need an index that is 1/10 of another index? It’s all because of options and sizing of positions.

Options on SPX don’t represent 100 shares in SPX because SPX doesn’t have shares. Instead, SPX options represent a value of 100 times the value of SPX. Think of it as if SPX had shares and the options represented 100 shares, even though there aren’t any shares. XSP options represent 100 times the value of the XSP. So, in both cases we still have a multiplier of 100 as we do with ETF options. This is where the similarity in options end.

One difference is that dividends are not part of the S&P 500 index. Many of the 500 stocks in the index pay dividends at various times throughout each quarter, and those payments have an impact on the individual stock price, which will then impact the price of the index. But the index has no mechanism to pay dividends because it is just an average of the prices of the 500 stocks it tracks and isn’t tradable itself. So, option buyers and sellers of SPX and XSP don’t have to consider dividends as an event, like traders in the SPY ETF.

Since index options can’t be settled in shares, they settle in cash when they expire. In many ways, this can be a lot easier. If an option expires $5 in the money, a call buyer will receive $500 from the account of the call seller at expiration because of the 100 multiplier. If an option expires out of the money, it is worthless and there is nothing to settle.

Cash settlement can be a bit confusing at first, so just realize that there is nothing to actually buy or sell from assignment- a put seller that is assigned doesn’t have to buy 100 shares, they just have to pay the difference in the current price at expiration from the strike price of the option. If the trader sold a put on a stock or ETF, they would be assigned shares that they would buy for more than the current price, which they could turn around and sell at a loss. Index options eliminate the step of buying and selling shares, and just settles the difference in price with cash.

Index options use European style option assignment, while stock and ETF options use American style options. American style options can be executed at any time by the option buyer, and this becomes a consideration for option sellers that have positions in the money before expiration. However, European style options can only be executed at expiration. So, sellers of index options don’t have to worry about having an early assignment before expiration, and buyers don’t have that option. And since index options are cash settled, there really isn’t an “option” at all. In the money index options are simply “settled” at expiration.

SPX options have lots of different expirations. Originally, these options only had expirations once a month on the third Friday of the month. Later, month end and quarter end expirations were added. Then weekly expirations every Friday were added. And now there are Monday and Wednesday expirations. Soon, maybe by the time you read this, there will be options expiring every trading weekday when Tuesday and Thursday are added.

One holdover from the original monthly expiration is that monthly index option expirations are different than all the other expirations in a couple of ways. First, and most importantly, monthly index options expire in the morning (AM) of expiration, while all other expirations expire at the close (PM) of trading. For SPX, there are actually two option expirations on the third Friday of the month, the monthly AM expiration, and the Friday PM weekly expiration. The settlement price for AM expirations of SPX is based on the opening trade price of each of the 500 stocks of the S&P 500 index. After each of the 500 stocks has traded on expiration morning, the prices are calculated to determine a settlement price for expiration. However, trading on the expiring option is stopped at the close of trading the day before. So, SPX option sellers and buyers are stuck with their positions from Thursday afternoon until Friday morning not knowing what the index price will be for settlement until the market actually opens and sets the price. For PM expirations, it is simpler, when the market closes, option trading stops and expiration settlement is based on the price of each of the 500 stocks in their last trade of the day. If you watch the price at the closing bell, you will see it change slightly by several cents after the close as all the different orders that execute at the market close get accounted for. The second way that AM and PM expirations vary with index options is that when the option contract is listed, monthly contracts use the ticker symbol SPX, while all other expirations use SPXW. The W is for weekly, even though the expirations may be quarterly, monthly, Monday, or Wednesday, and soon Tuesday or Thursday. So for S&P 500 Index options, just know that SPX listed options expire in the morning (AM) and SPXW listed options expire in the afternoon (PM). Either way, when you are searching for option listings, most brokers list SPX and SPXW options together under SPX.

XSP options are a more recent creation, and only have PM expirations. There aren’t different naming conventions either. Settlement works the same, with prices set by the final trade of each of the 500 stocks of the index when the market closes.

Another difference between SPX and SPY options is that SPX options are traded in increments of 5 cents. Since SPX is 10 times the price of SPY or XSP, trading increments or tick size is actually more precise on a percentage basis for SPX. XSP trades in increments of one cent like SPY. SPX options are also very liquid and orders can usually be filled 5 cents away from the mid price, even in multi-leg orders. There is a little difference based on trade volume of different expirations. Monthly expirations typically have the most volume, followed by Friday PM expirations and month-end expirations. Monday and Wednesday expirations have the least volume and can sometimes be slightly harder to fill, especially for strikes away from the money with more than a week until expiration.

XSP have a lot less volume than SPX or even SPY options, so they can be a little less liquid. Because of their pricing, they trade very similar to SPY, but with a little less liquidity. Since XSP is an index option, there is no worry of assignment, and dividends are not a consideration.

Some brokers don’t allow trading of index options in their accounts, and some strategies are not allowed with index options in certain types of accounts. Some brokers charge higher commissions and fees for index options than for stock and ETF options, so watch out!

Finally, index options get a different tax treatment and have a different accounting treatment at the end of the calendar year. Index options fall under Section 1256 of the tax code which allows a trader to classify 60% of the gains from trading index options as long term, while only 40% are short term. For taxable accounts of traders in mid to high tax brackets, this can be a significant advantage! It doesn’t matter if the option was held for a minute or six months, the 60/40 tax assignment applies. The other part of 1256 treatment is that index option positions are “marked to market” at the end of the year, meaning that a trader considers the option to be a profit or a loss at the end of the year even if the position is still open based on the price at the end of the year of open positions. In stocks and stock options, only positions that have been closed are evaluated for a profit or loss. Using mark to market can be a bit confusing the first time around, but most brokers do all the calculations and provide them in a year end tax statement.

The CBOE has announced another index option on the S&P 500 index to start trading very soon, call Nano options. This index will be 1/1000 of the SPX, or 1/100 of XSP, to allow very small option trades on the S&P 500. Supposedly the ticker symbol will be NANOS. Stay tuned for more details.

Futures Options

There are two futures contracts on the S&P 500 index that offer options. The primary one is called the E-Mini S&P 500 Futures, which uses the symbol /ES at most brokers. In listings of futures contracts and futures options the symbol will be followed by a letter to designate the month the future expires and a number for the year of expiration- for example /ESH2 represents the future contract expiring in April of 2022. The other futures contract is called Micro E-Mini S&P 500 Futures, and uses the symbol /MES. Some brokers may use other characters to designate futures instead of the forward slash, and some may require approval of futures to even see the ticker symbols. Consult with each broker for details.

Futures are tradable contracts based on the price of the underlying index at the expiration of the contract. Futures contracts in general expire at a variety of times in the month with /ES and /MES expiring on Wednesday mornings and settling to opening prices of the S&P 500 index. Since the futures contract is based on what the market expects the price to be at expiration, the price of the future is usually a little less or sometimes a little more than the current value of the S&P 500 index. However, it generally doesn’t vary that much because the current price is one of the best indicators of what the future price might be and futures buyers and sellers won’t let the prices to diverge that much because it presents an opportunity for arbitrage between the different values, knowing that at expiration they will converge. At any given time, there are many different contract expirations available to trade, going months out in time. The contract month closest to expiration is called the front month. Buying a front month futures contract is as close to directly owning the S&P 500 index as you can get. The value of the futures contract goes up and down with the index.

A single /ES contract is valued at 50 times the S&P 500 index. One might think of it as owning 50 shares of the S&P 500 index if the index price were the price of a share. A single /MES contract is valued at 5 times the S&P 500 index. These values are known as the notional value. However, futures contracts are priced at prices similar to the actual S&P 500 index, regardless of the notional multiplier.

Let’s take an example. Let’s say that the S&P 500 index is currently at 5010, and front month futures contracts for both /ES and /MES are trading at 5000 as they are slightly less. The /ES contract would have a notional value of $250,000, and the /MES would have a notional value of $25,000. If the market went up 100 points on the S&P 500, and both /ES and /MES went up to 5100, the owner of one contract of /ES would make $5000, and the owner of /MES would make $500. For most people $250,000 for one contract is too expensive, but futures contract owners aren’t required to have the full amount in their account, but just a fraction due to the assumption that the price will only move within a small percentage of the index price. If the price moves more than expected against a contract owner or seller, additional capital will be required. This practice is called span margining, and can be very helpful to allow traders to leverage a position, but also very dangerous if over-used and the market moves against a position. For example, if a trader buys an /ES contract priced at 5000 and has $50,000 in their account, a 20% decline in the market to 4000 would wipe out the account. While /MES is one tenth the size, the problem can be the same for a trader with a smaller account.

So far we’ve talked just about the futures contracts themselves. The topic of this post is trading options on the S&P 500 index, not trading futures on the S&P 500 index. So, let’s talk about how options on futures work. In particular let’s look at options on /ES and /MES. One key difference from other options we’ve looked at is that /ES and /MES options don’t use a 100 multiplier, like stocks or index options. Instead, futures options are an option to buy or sell one single futures contract. Which futures contract is the option associated with? Typically, it is the futures contract that is next to expire after the option expires. So, an option on /MES expiring on the first Friday in March is tied to the March futures contract, which will still have time remaining when the option expires.

So, buying an /ES call gives the buyer the option to buy one /ES futures contract at option expiration, and buying a /MES put gives the buyer the option to sell one /MES futures contract at option expiration. So, settlement of the option at expiration doesn’t settle in stock or in cash, but in a futures contract. The price paid for the futures contract is the strike price of the option. For example, if a trader buys a call option for /ES with a strike price of 5000, they would get to buy an /ES futures contract at options expiration for $5000, multiplied times the /ES futures multiplier of 50, or a total of $250,000, assuming that /ES is trading above 5000, making the option in the money. On the other hand if the price of /ES is below the strike price of the call option, the option would expire worthless. Similarly, if a /MES 5000 put expired in the money, the settlement would be to sell a /MES futures contract for $5000 multiplied times the futures multiplier of 5, for a total of $25,000.

There are futures options for /ES and /MES that expire every Monday, Wednesday, and Friday, so there are plenty of expirations to choose from. And futures and futures options trade virtually around the clock, from Sunday afternoon until Friday afternoon. In fact, the price of /ES in the overnight hours moves around quite a bit based on news and as the opening of the market approaches, it is a fairly accurate indicator of where the market will open. Meanwhile the S&P 500 index stays the same during the overnight, because it is based on a calculation from the trading of the 500 stocks in the index, which don’t broadly trade at night.

The span margining ability to trade using the buying power associated only with a calculated expected move applies to futures options as well as futures contracts. As a result, traders can put on highly leveraged trades without consuming a lot of buying power. With this capability comes significant risk. Traders have to be very aware at all times of the true total risk that comes with trades in futures options. With futures options, the buying power used is not a good indicator of the capital at risk in the case of a very large move of the market up or down. Some brokers allow selling of naked futures options for very little buying power, where selling the same notional value of SPX or SPY could easily require ten times more capital even though the true risk is the same. Many trading strategies with futures options may seem very safe because they are high probability trades- perhaps they win 90% of the time- the problem is when the losing 10% happens and the trader is not prepared for the damage that occurs to the account. Risk management is critical in all options trades, but particularly in futures options using span margin. Stops and hedges become the difference between staying solvent and going broke.

Like index options, futures and futures options also use section 1256 tax treatment with 60% long term gains and 40% short term gains, and are marked to market at the end of the year. There are no dividend risk issues.

One final unique advantage to futures options is that they are exempt from the Pattern Day Trade rule. For accounts under $25,000 where trades are opened and closed the same day, a trader can have severe limitations placed on an account. Generally, the limit is five day trades in a rolling seven day week. This can be stocks or options. Futures and futures options are governed by different regulations, so many day traders favor futures.

Many brokers have significant approval processes to be allowed to trade futures or futures options. Some limit them only to standard taxable margin accounts. Other brokers don’t allow them at all. Go to the office of your broker and see if anyone there has any experience trading futures or futures options- it is likely no one there has a clue and they will tell you not to do it. If you have friends that trade in the market, chances are that almost none have ever traded a future or futures option, so you are likely on your own. Your best source for help will be specialist from your broker’s headquarters, specialized training materials, or online resources from your trading community as I discussed in an earlier post.

If trading futures options is so complex, hard to understand, and risky, why do it? For many strategies, futures options can fill in gaps at a low capital requirement. Some hedging strategies can be too expensive with stock or index options, but more affordable with index options. Because of the unique multipliers, futures options for the S&P 500 index may be just the right size for a particular need. And finally, because the futures prices move and trade all night, futures and futures options allow trading on that information at some brokers.

Review of choices

After a lot of discussion and explanation, we have come up with seven choices for trading options on the S&P 500 index. Five of these are directly correlated to the index, and two are leveraged. Remember that the UPRO ETF moves up and down with the S&P 500 index, but three times as much each day. SDS, the UltraShort ETF not only moves the opposite direction of the S&P 500 index, but twice as much in the opposite direction on a percentage basis each day. Because of this leverage, the options on these two ETFs behave in unique ways which can be helpful for some strategies. However, most traders are more likely to want options that are based on underlying entities that move on a 1:1 basis with the S&P 500 index. So let’s review those choices.

TickerTypeIndex vs
Strikes		# of Shares
or Multiplier		Notional
Value @
SPX = 4000		Settle
as		Tax
Treatment
SPXindex1 : 1100$400,000cash60/40
/ESfutures1 : 150$200,000one contract60/40
SPYETF1/10100$40,000100 sharesshort term
XSPindex1/10100$40,000cash60/40
/MESfutures1 : 15$20,000one contract60/40
This table lists key differences in the five main choices for options on the S&P 500 index, listed in order of notional size. In this table notional value refers to the amount of capital controlled by a single option with a strike tied to the S&P 500 index being at 4000 (SPY and XSP would have strikes at 400, while SPX, /ES, and /MES would have strikes at 4000).


While SPY is the simplest choice because it is most readily available, there are reasons to consider each of the other listed choices to best meet the needs of a specific account or strategy. From biggest to smallest, SPX controls 20 times as much capital as /MES, and the other choices provide increments in between. I was personally reluctant to trade futures options at first, but for no good reason other than I wasn’t familiar with their nuance. As I write this, I currently have at least one contract of each of these five choices open amongst the various accounts I manage.

For all of our choices, we currently have the ability to select expirations three days a week, and potentially five days a week in the near future. Each choice has an extensive selection of strikes available at each expiration, although one can expect Friday expirations and month end expirations to have more choices and more trading volume than Mondays and Wednesdays. We expect third Friday (monthly expirations) to have more choices and trading volume than any other expiration in the month.

My personal preference in most situations is SPX due to its large size. Even though commissions and fees are more on a per contract basis, the fact that SPX is 10 times bigger than SPY or XSP makes commissions and fees almost negligible in most trades of SPX, where they can be a substantial consideration with SPY and XSP in some strategies that deliver narrow profits. For futures, I like /ES over /MES for the same reasons. However, when I’m trying out a new strategy or working with a small account, I often have no choice but to use SPY, XSP, or /MES. For most new traders, SPY is the first and easiest choice, but eventually there may be a need to use another choice. For example, if you start trading 10 option contracts at a time, it might make sense to use SPX. If SPY is too big, you may want to get approval to trade futures and trade options on /MES. If you have a taxable account and are in a higher tax bracket, XSP may be a good alternative to SPY to reduce short term capital gains. So, learn the differences and make the choice that makes the most sense for the situation.

If you want to investigate strategies for trading options on the S&P 500 index, take a look at some of my favorite strategies. You may also want to read my page on how different option strategies have very different risk profiles.

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