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

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

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

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

An example of a currency quote is as follows:

**EUR/USD 1.1600**

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

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

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

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

**USD/EUR .8621**

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

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

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

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

**EUR/USD = 1.1600/05**

**Bid = 1.1600**

**Ask = 1.1605**

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

**To summarize Forex pricing:
**

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

• The Bid price is used when selling currencies

• The Ask price is used when buying currencies

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

• The spread is called a pip, or point

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

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

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

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

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

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

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

We look forward to seeing you on the webinar!

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

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

**What is long Gamma?
**

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

**What is short Gamma?**

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

**How Gamma and time are related…**

Time affects Gamma.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

**Summing it up…**

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

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

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

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

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

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

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

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

**How is momentum defined?**

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

**What is divergence?
**

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

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

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

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

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

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

Figure B. Bullish Divergence chart from Think or Swim

Figure C. Bearish Divergence chart from Think or Swim

**How can traders interpret divergence?**

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

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

**In conclusion …
**

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

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

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

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

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

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

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

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

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

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

Figure A. PYPL 21 SEPT 18 Option Chain

**What is the Intrinsic Option Value?**

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

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

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

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

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

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

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

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

**What is the Extrinsic Option Value?
**

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

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

The extrinsic value of an option is many times referred to as “the time value”. The time value is one of the primary elements which affects the premium of an option.

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

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

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

**Calculating the Extrinsic Value of an Option**

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

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

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

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

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

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

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

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

**Summing it up…
**

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

Please leave a comment below to add to the conversation.

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

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

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

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

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

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

Breaking this outcome into percentages:

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

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

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

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

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

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

**How is the SKEW Index calculated?
**

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

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

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

Figure C. 3 year weekly SKEW Chart

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

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

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

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

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

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

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

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

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

Figure D. VIX/SKEW 1 year Daily Chart

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

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

Figure E. SPX 1 Year Daily Chart

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

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

**In summary …
**

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

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

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

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

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

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

You will find a wide variety of educational services in addition to the trading groups that meet on a regular basis to exchange their trades and ideas.

]]>There are hundreds of options trading “gurus” promising you all kinds of ridiculous returns like “5% per week” or “10% per month”. What most traders don't realize are the risks that come with those returns.

As a reminder, options expire on the third Friday of every month. Weekly options, first introduced by CBOE in October 2005, are one-week options as opposed to traditional options that have a life of months or years before expiration. New series for Weekly options are listed each Thursday and expire the following Friday. In fact, many stocks now have weekly options going as far as 5 weeks.

Not every stock or index has weekly options. For those that do, it means that every Friday is an expiration Friday. That opens tremendous new opportunities but also introduces new risks which can be much higher than “traditional” monthly options.

Question from a reader: What about selling the weeklies? The timeframe is very short and if you are more conservative, you can skip the weekends and start the trade on Monday and bet on about 4 days. You can still get about 10% return per week with very little risk.

To earn 10%, you must allow the options to expire worthless. That involves much more risk because each day comes with the tiny possibility of market-moving news.

If you can earn 10% per week and compound those earnings, after one year, $1,000 would become $142,000. I’m sure you cannot expect to win every week, but I hope that you recognize that it is impossible to earn such reruns with low risk.

I believe that your plan is fine for the experienced, disciplined trader who is skilled at managing risk. However, it is far too dangerous for the novice trader.

Many options “gurus” ride the wave of the weekly options and describe selling of weekly options as a cash machine. They say that “It brings money into my clients account weekly. Every Sunday my clients access their accounts and see + + +.” They advise selling weekly credit spreads and present it as a “a safe option strategy because we’re combining an option purchase with an option sale resulting with a credit into your account”. What is the biggest issue with selling weekly options? The answer is the negative gamma.

The gamma is a measure of the rate of change of the delta. The gamma of an option is expressed as a percentage and reflects the change in the delta in response to a one point movement of the underlying stock price. For options buyers, the gamma is your friend. For options sellers, the gamma is your enemy.

Selling weekly options will give you larger theta per day. But there is a catch. Less time to expiration equals larger negative gamma. That means that a sharp move of the underlying will cause much larger loss. So if the underlying doesn't move, then theta will kick off and you will just earn money with every passing day. But if it does move, the loss will become very large very quickly. Another disadvantage of close expiration is that in order to get decent credit, you will have to choose strikes much closer to the underlying.

Here are some mistakes that novice traders do when trading Iron Condors and/or credit spreads:

• Opening the trades too close to expiration. There is nothing wrong with trading weekly Iron Condors – as long as you understand the risks and handle those trades as speculative trades with very small allocation.

• Holding the trades till expiration. The gamma risk is just too high.

• Allocating too much capital to weekly options.

• Trying to leg in to the trade and time the market. It might work for some time, but if the market goes against you, the loss can be significant and there is no another side of the condor to offset the loss.

Does it mean you should not trade weekly options? Not at all. They can still bring nice gains and diversification to your options portfolio. But you should treat them as speculative trades, and allocate the funds accordingly. Many options “gurus” describe those weekly trades as “conservative” strategy. Nothing can be further from the truth.

]]>Many investors consider the foreign exchange market (also referred to as Forex or FX) to be one of the most intriguing and exciting markets in the world. The foreign currency market is an extensive subject; and too vast to cover in one article. Today we will cover the basic elements of the Forex, and some important considerations for traders to be aware of before deciding if the currency market is suited for their own trading style and risk tolerance.

The foreign exchange market is where currencies from all over the world are traded. The trading of foreign currencies is a necessity, as an exchange must occur between two countries in order to conduct business.

As an example, let's say a Swiss tourist was travelling in Peru and wanted to visit the historic ruins of Machu Picchu. The tourist is unable to use his Swiss francs for the entrance fee because it is not the local currency in Peru. He must exchange his Swiss francs for the Peruvian Sol (PEN), at the current exchange rate in order to visit the ruins.

In another example, you live in the USA and want to purchase wine from Portugal, which you order from your local wine retailer. The importer the store purchases the wine from will likely need to exchange the equivalent of US Dollars (USD) into Euros (EUR) in order to purchase the wine for you.

Because the need to exchange currencies around the globe is so great, the Forex market is considered to be the most liquid and largest financial market in the world. Comparing the Forex market with the stock market illustrates the magnitude of the Forex market. According to the Bank for International Settlements (BIS), the average daily volume of the Forex market at the end of 2017 was just over $5 trillion, changing constantly as more and more currencies are traded. The stock market is dwarfed in comparison, with an average daily volume of $55 billion on 6/29/18, as reported by the NYSE (New York Stock Exchange). One trillion equals 1,000 billion, so you can see the magnitude of the size of the Forex market.

**Understanding how currencies are quoted can be confusing at first …**

When a currency is quoted in the Forex market, it is always done in relation to another currency; the value of one currency is reflected through the value of another. This is called a currency “pair”. The USD/CHF is an example of a currency pair. The currency to the left of the slash (USD or US Dollar) is the base currency, and the currency on the right of the slash (CHF or Swiss Franc) is the counter currency, or quoted currency. The base currency is always equal to one unit. Therefore, if you wanted to determine the exchange rate between the US Dollar (USD) and the Swiss Franc (CHF), the Forex quote would look like this: USD/CHF = .9899.

There are two ways a currency pair is quoted; direct or indirect. A direct currency quote is a currency pair in which the domestic currency is the quoted currency. An indirect quote is a currency pair where the domestic currency is the base currency. So, if you were looking at the Swiss Franc (CHF) as the domestic currency and the US Dollar as the foreign currency, a direct quote would be USD/CHF, meaning that US $1 will purchase .9899 CHF. In this same example, an indirect quote would be the inverse (1 divided by .9989), 1.01 CHF/USD. This means with $1 Swiss Franc, you can purchase $1.01 US Dollars.

Most currencies are traded against the US Dollar, so in the majority of countries the US Dollar is the base currency, or a direct quote. However, this is not the case in currencies referred to as the Queen's currencies, or those that have or have had a tie with Great Britain. Examples of these include the New Zealand dollar (NZD), Australian dollar (AUD), as well as the Euro (EUR). In these cases, the US Dollar is the counter (quoted) currency, so it is referred to as an indirect quote.

**What is a Cross Currency?
**

There is yet another term to become familiar with when learning the Forex language, and that is a cross currency. A cross currency is when a quote is given that does not include the US Dollar as one of its elements. Some common cross currency pairs include the EUR/CHF, EUR/GPB, and EUR/JPY. They present additional trading opportunities, but they are not as widely traded as pairs that include the US Dollar, referred to as the “majors”.

We'll cover more about pricing … bid/ask, spreads, etc., in a future article, but for now you have the basic language that is used in the Forex trading world on how currencies are quoted.

**What are some of the advantages of trading the Forex market?**

- While there are thousands of instruments traded in the equities market, the majority of those who trade the Forex market focus on seven different currency pairs. These include:

1) EUR/USD

2) USD/JPY

3) USD/CHF

4) GBP/USD

5) USD/CAD

6) AUD/USD

7) NZD/USD

These seven are considered to be the “majors”, and all other pairs are different combinations of the same currencies, called “cross currencies”, as explained above. This can make trading currencies easier to follow. Rather than following thousands of stocks, indices, or ETFs, Forex traders only need to stay abreast of the economic and political news of the countries in the major currency pairs.

- The currency market is open for trading 24 hours a day, 5-1/2 days per week. Market hours are from 5:00 PM ET Sunday through 5:00 PM ET Friday. This can be advantageous for traders who have a job during the day. As you can see from the chart below, the major currency hubs are spread across many different time zones. Some currency markets are open before the opening bell in the United States, while others open as the US markets close.

Figure A. Forex Market Time Chart (courtesy of Investopedia)

- The Forex market has much more liquidity than the equity market, which can make it easier to enter and exit positions.
- Commissions can sometimes be much lower in the Forex market than the equity market. Most Forex brokers create their profit from the spreads between the currencies.
- Because of the high liquidity in the Forex market, margins are lower than the equity market. Most brokers in the equities market require at least 50% of the value of the investment for margin. In comparison, Forex brokers can require as little as 1%.
- A Forex trader has the ability to choose various levels of leverage. This allows the trader to choose the risk/reward that fits their comfort level.

**Is there a downside of trading in the Forex market?**

The high leverage available to traders in the Forex market can be a double-edged sword, and brings a higher risk in comparison to trading equities. This high leverage means that any gains can quickly turn into major losses in a matter of minutes.

What is leverage?* “Leveraged investing is a technique that seeks higher investment profits by using borrowed money. These profits come from the difference between the investment returns on the borrowed capital and the cost of the associated interest. Leveraged investing exposes an investor to higher risk”* according to Investopedia.com.

While currencies normally don't move as dramatically as equities on a percentage basis, it is the leverage in the Forex market that creates the volatility. For example, if you are using 50:1 leverage on a $1,000 investment, you control $50,000 of capital. If you invest $50,000 into a particular currency and that currency's price moves 1% against you, the value of that capital has decreased to $49,500 – a loss of $500. This loss represents 50% of your investment.

Compare this to the equities market, where most traders do not use leverage… Using the same example of investing $1,000 into a particular stock: If that stock price drops 1%, the loss incurred would only be $10, 1% of your investment. It is critical that traders be aware of the risk of leverage before diving into the Forex market.

**In conclusion …**

Trading the Forex market can be an exciting and diverse addition to a trader's tool box. The liquidity of currencies, and being able to trade outside the US market hours, has its advantages. However, as with any instrument or trading strategy, trading the Forex market comes with risks associated with the benefits. Be sure you have a complete understanding of all the risks and the potential effect they can have on your trading capital before investing in the currency market.

This introductory article barely scratches the surface of the vast Forex market. Future articles will cover more specifics of trading the foreign currency market such as bid/ask pricing, spreads, and pips.

If you trade currencies and have any experiences you would like to share to subscribers, feel free to comment below.

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

Exchange Traded Funds (ETFs) are funds that track indexes such as the S&P 500, Nasdaq 100, Dow Jones Industrial Average, Russell 2000, etc. When an investor buys shares of an ETF, they are actually buying shares of a portfolio that tracks the yield and return of the related index. By purchasing an ETF, investors get the diversification of an index fund, but at a much lower cost. Some ETF shareholders are also entitled to a portion of the profits, usually paid quarterly, in the form of dividends. The use of ETFs is a popular choice among traders.

Today we will talk about a family member of the traditional ETF, Inverse ETFs. We'll cover just what inverse ETFs are all about, and how traders may use them in their trading.

Similar to traditional ETFs, Inverse ETFs also track indexes such as the S & P 500, Nasdaq 100, etc., but they are comprised of multiple derivatives designed to benefit (profit) from a decline in the value of the underlying benchmark. This is the opposite of traditional ETF's. Inverse ETF's are also referred to as a “Bear ETF”, or “Short ETF”. Inverse ETF's are mainly used by traders that either day trade, or hold onto the position for only a few days. Some traders use them as a short-term portfolio hedge, others who day trade may take a speculative trade on an Inverse ETF if they anticipate the underlying to decline.

There are many Inverse ETFs available to traders. A list of all Inverse ETFs currently available in the USA can be found here: Inverse ETFs

Today we will look at some Inverse ETFs that track the four major indices. Below are one year charts of the S & P 500, Russell 2000, Nasdaq 100, and Dow Jones Industrial Average indices. Overlaid on each chart is the corresponding Inverse ETF chart that correlates with the index.

**Figure A**. One year chart of the S & P 500 and the Inverse ETF SH

**Figure B**. One year chart of the Russell 2000 and the Inverse ETF TWM

**Figure C**. One year chart of Nasdaq 100 and the Inverse ETF PSQ

**Figure D**. One year chart of the Dow Jones 100 Industrial Average and the Inverse ETF DOG

You can see how price movement of the Inverse ETF (blue line) in each of the above charts has been in the opposite direction of the index itself (red and green line).

- Inverse ETFs can be used as an alternative to short selling, i.e. selling a call, to hedge a portfolio against downside risk . Because they are purchased, a margin account is not required. This can be a benefit for those who trade in Individual Retirement Accounts, where there are restrictions on taking a short position. Inverse ETF's allow any trader with a brokerage account to hold a short position if they feel the underlying will go down and they want to hedge their portfolio. For example, if a trader feels that the Nasdaq 100 will decline, he/she could simply buy shares of PSQ, or open an option trade on the Inverse ETF PSQ.
- Your risk is limited when purchasing an Inverse ETF. When you short an underlying, the losses could be significant if the market moves against you. With an Inverse ETF, your exposure is limited to the cost of the ETF or option.
- It is also possible for a trader to purchase an Inverse ETF on a specific sector, such as financials, energy, or technology. If an investor is bearish on any one of these sectors, they may want to purchase the Inverse ETF for which that sector is associated.

- Inverse ETFs are best suited for those traders looking for a short term hedge, not as a longer-term investment. The reason is that many Inverse ETFs utilize daily futures contracts as a basis for their returns, which can fluctuate dramatically in price from day to day. Because of these potential wild swings, pricing is not always accurately representative of the index they correlate with when held longer than a day. Day traders may find Inverse ETFs a very effective addition to their trading plan.
- Open interest can be low on some of the options for the Inverse ETF's, which means it may be difficult getting filled at the price desired. This low open interest will most likely create a wide bid/ask spread, which could potentially create lower profits along with greater losses than anticipated.
- Some, but not all, Inverse ETFs are leveraged, which can act as a double edged sword.

**What is leverage?** *“**Leveraged** investing** is a technique that seeks higher investment profits by using borrowed money. These profits come from the difference between the investment returns on the borrowed capital and the cost of the associated interest. Leveraged investing exposes an investor to higher risk”* according to Investopedia.com.

Let's say you purchased an Inverse ETF which is leveraged at 2x for a cost of $100, and it ends up at the end of the day at $110. The profit would be 10% for the day. Because the Inverse ETF is leveraged, you would realize a 2x profit of 20%. This can work the same way if the position goes against you. Let's say that this same Inverse ETF position goes against you the next day, and the value falls from $110 to $100, a loss for the day of 9%. The trader realizes a 2x loss on of 18%.

While this may not be that harmful on a small position, those losses can be significant depending on the size of the position. If the ETF you are considering is leveraged at 3x, it would mean that the profits AND losses would be three times greater than if there was no leverage.

In conclusion, investing in Inverse ETFs can be a useful tool for some traders. It may be worth considering the use of Inverse ETFs in your trade plan. It is wise have a full understanding of all the benefits – and risks involved. Be sure to know whether the Inverse ETF you are considering is leveraged, and to what extent, etc. Knowing all the risks involved in trading Inverse ETFs, as with any investment product, can help you make informed decisions on your trading.

If you have any experience on how you have used Inverse ETFs in your trading and would like to share, feel free to comment below.

Are you looking for a trading group, educational alert service, or mentoring? Look no more; join now!

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A covered write is more commonly known as a covered call.

Dan has an example of XYZ stock (I love XYZ stock…)

+100 XYZ stock @ 90.00

-1 Aug 95 Call @ 1.00

Dan made a few statements that I need to comment on:

– **Dan says that he sells in-the-money calls if he is bearish.** Why would you sell ANY covered calls if you are bearish? Covered calls are a bullish strategy. Since Dan only goes out 30-days, he doesn't give his bearish outlook much time to change to a bullish trend.

– **Why would someone do this?** Dan's answer is extra income. A better answer is to reduce volatility of your returns, which will improve your returns in the long run. Income is nice if the stock stays in a range of course, but the reduction in the volatility of your returns is the most important benefit in my opinion.

– **What's the problem with this trade?** Dan says cost.

In Dan's example, the return for one month is $100 on $8900 of margin required, or +1.12% in one month. That is +13.5% per year.

Dan says that replacing the long stock with a long call ( +1 Feb 2019 75 Call for @ 18.00 ) has a higher yield. It does have a higher yield but that's not the whole story.

The real question is how much risk are you subjecting your account to?

Let's assume you had a $10,000 account and could put one covered call trade on. You could afford to put several diagonals on but you would be over leveraging your account.

Yes you'll make a lot more if the stock goes your way; however, you'll lose a lot more if the stock moves against you.

The covered call costs $8900 while the diagonal costs $1700 ($18.00 – $1.00)

Both trades are trying to make $100

The yield on the entire account is the same but the margin used is not. Dan can't claim that the diagonal is better because it has a higher yield. The yield on the account should be the same if you are trying to generate a $100 profit from either strategy.

Most people will put more trades on, either in XYZ or in something else.

Doing this will* over leverage* the account.

Let's see how.

In a $10,000 account, you could put five $1700 trades on for $8500 of margin used. (Pretty close to the margin from the covered call).

Let's say the stock either makes or loses $100 for each trade.

The covered call with either gain or lose 1.12%

The diagonal will gain or lose $500, or 5%

The covered call lost $300, or -3% of the entire account.

The diagonal would lose $1500, or -15% of the entire account.

If you lost -3% of your account, you need to earn +3.1% to get back to break even.

If you lose -15% of your account, you need to earn +17.6% to get back to break even!

Now assume the market really crashed and the covered call lost -$1000, or -10% for the entire account. You need to make +11.1% to get back to break even.

The diagonal will lose -$5000, or -50% of the account. **You need to make a 100% return just to get back to break even!**

You can see how over leveraging becomes a **catastrophic event for your portfolio**.

- Stock has +100 Delta. Dan's deep-in-the-money call might have a +85 Delta. If the stock is moving higher, the covered call will be making money faster.
- On the flip side, if the stock is moving down, the covered will be losing money faster.
- If you own the stock, you can collect dividends which may have favorable tax treatment if held over 60-days for common stock and 90-days for preferred stock.
- Stock has the ability to put married puts to absolutely limit risk. Dan Harvey and I prefer this method over covered calls or diagonals.

Selling a covered call is very similar to a diagonal; however, the diagonal has the temptation to over leverage your account. Over time, this will hurt your performance as losses are magnified and time to recover from the losses will increase. If you are bearish on a stock, DO NOT SELL COVERED CALLS! They are a bullish strategy.

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