How to Create a U.S.-Based Brokerage Account Even if You Don’t Live There

International stock and options traders outside the United States are a fast growing segment of the investor population. The steady release of new products like forex, commodity ETFs and currency options trading on U.S. exchanges have even more international traders looking to access the U.S. markets.

[VIDEO] How to Create a U.S.-Based Brokerage Account

Learning Markets has a large international readership and a question we get frequently is how to set up a brokerage account inside the U.S. if you don’t live there. Because a U.S. based account may be the most efficient and cheapest way to access the U.S. exchanges we feel that this is an important question.

Setting up a stock or options brokerage account is a subject we have discussed before and there are very few changes that a trader from outside the U.S. needs to worry about.

The biggest issue is usually that it may take a little extra time to establish the account than if you were setting one up from inside the U.S. The list below should help you understand what you will need to do to get started.

Account Application

The account application is a long form that all account holders have to fill out. It includes contact information, trading objectives questions and disclosures. Most discount brokers in the U.S. allow you to fill this application out online and even sign it electronically.

However, applicants from outside the U.S. must send, scan or fax in a hard copy. This is annoying but not a big issue.

IRS Form W8

This is a form the broker will get from you and return to the Internal Revenue Service, which is the tax collection arm of the U.S. Treasury.

The form identifies you as a foreign person and usually has to be returned to the broker in hard copy. Its about a page long but usually only takes a few minutes to fill out.

Call Your Prospective Broker(s)

If you are considering opening an account with a broker inside the U.S. make sure you are calling or contacting their customer service departments about the process before filling out the application. This accomplishes several things at once.

  1. You will find out whether they accept international accounts – not all brokers do.
  2. Customer service can explain what the process and commissions are like for international accounts. For some brokers, setting up an account is easy and for others it can be long and difficult. There is no need to increase your work load unduly.
  3. Contacting the brokerage service department is always a good idea regardless of where you are located. This will give you a taste for what working with the broker will be like. Were they courteous, knowledgeable, responsive…? Did they provide the ability to chat online rather than a phone call if you prefer that method?

These are all things you will find out and it will make a big difference if you ever have issues in the future.

1099s

If you were a resident or citizen of the United States you would get a 1099 form at the end of the year with your profits or losses from your broker. Most firms use an outside processor to send this form out and they usually don’t differentiate between domestic and foreign account holders. If you are outside the U.S. this form may not apply to you and you will want to discuss it with a local tax adviser.

The bottom line is that the process of setting up a brokerage account inside the U.S. is usually no more difficult than if you were inside the U.S. It just may take a little extra time to print and then fax, scan or ship your documents to the broker.

 

Image courtesy Sam Churchill.

Why Most News is Meaningless

The news is a tricky subject for most investors. Real time feeds with hundreds of articles are now streaming to even small account holders. This flow of information can be confusing and is quite often meaningless. In order to differentiate their product from their competitors, financial news producers now try to report the “whys” behind market movement rather than just the “whats.” This is a problem that catches a lot of investors off guard and can lead to bad conclusions.

[VIDEO] Why Most News is Meaningless

The truth is that no one fully understands the whys behind market movement in the short-term. There are a few things we understand in general but it is extremely rare that market movement can be attributed to a single news event on a given day. This article will use two case studies to illustrate its point and will conclude with a few suggestions for harvesting the legitimate value from financial news reporting.

1. Economic Announcements

General economic releases often are blamed as the cause for volatility in the market. A recent headline is a great example of this; it read “Rise in Jobless Claims Weigh on Stocks.” This article title seems to make sense on the surface; if jobless claims are rising then stocks should suffer. The day this article was released (4/23/2009) the market was down slightly and therefore the logic seemed sound.

Unfortunately the cause and effect suggested by this article can not be shown to be statistically true. A basic mistake made by financial writers is to confuse correlation with causation. Although the market went down on the same day jobless claims went up (correlation) jobless claims cannot be proven to have “weighed” stocks down (causation).

Lets walk through the logic the author presents. According to this writer, the market went down because jobless claims went up. This weekly number is important so the emphasis seems to make sense. Over the last 10 previous announcements the jobless claims rate increased significantly 4 other times. On these days the market closed up twice, ended virtually flat once and closed down once. This seems to be hardly predictive.

2. Earnings Reports

These news releases are issued by a public company on a quarterly basis. Although the releases can be shown to cause increased price volatility the direction prices move after the news is very random. This issue will not deter financial writers from attributing “whys” to the earnings news but the same statistical problems exist.

For example, that week Bristol Myers (BMY) released quarterly earnings with higher profits, bigger sales and lower costs. This was all done in spite of a stronger dollar, which can hurt BMY’s international sales. Fatter margins on higher sales sounds like a pretty rosy picture. However, despite the “good” news the stock fell and has continued falling.

In fact, over the prior 6 quarters BMY has exceeded earnings expectations and yet the stock is down significantly over that same 18 month period and was up or down randomly on the day of the earnings releases themselves. Why would a stock go down on good news? Not surprisingly this happens all the time.

Human beings are very uncomfortable with unanswerable questions. But the nature of the market is unpredictability which creates risk and a day to day reading of the news can’t reduce that risk in a predictive and meaningful way. The search for answers to the “whys” behind market movement will keep readers searching for writers willing to give them an improvable and probably wrong conclusion.

Does this mean that most news is meaningless? In many cases, yes. Major news producers are well aware of the issues behind financial news and it is common knowledge that they produce more than one story for earnings or other market events before the release only to publish the one that matches the event and market action right after.

However, there is hope and meaning behind the news when it is evaluated within the context of trend. For example, after a few years of very mild weekly unemployment claims, these numbers began escalating significantly in 2008. It was clear that the mild trend was ending and unemployment could become an issue. That was put to use by many investors who took a much more conservative stance in 2008 as a protection against an employment problem.

In the example of unemployment releases from 2005-2008 the news was useful because there was more data and therefore more statistical relevance. The outliers were smoothed out and real insight could be gleaned from the information. This is good news for investors. There is meaning in the news when used within context and trend and it does not require a real time news feed to get it.

 

Image courtesy futureatlas.com.

The Truth Behind Broker Commissions

When you trade a stock, fund or option, you pay a broker a commission to place the trade for you in the open market. Brokers compete fiercely for online commission business and they will try to differentiate themselves within the industry by offering the lowest commission rates.

[VIDEO] The Truth Behind Broker Commissions

It would seem that a straightforward comparison of broker commissions would easily show what brokers are truly leading the lowest-commission war. However, that is not the case. This article will discuss the reasons why comparison is difficult and what commission rates you should be paying the most attention to.commissions

Most online broker websites have a commission comparison table somewhere within their marketing information. Invariably, the major brokers will show themselves as the low cost leader compared to their competitors.

Disclosing commissions accurately is a regulatory requirement so how can all brokers show themselves as the cost leader and still be telling the truth?

Most brokers charge different commission rates for each kind of trade. Buying 100 shares of stock costs a different amount than buying 1,000 shares or a mutual fund or a bond or an option… you get the idea.

There is an extremely large number of possible trade combinations that will all cost a different amount. Most brokers can find some combination of trades, in which, they are the low cost leader. These costs may look good but probably does not reflect the way you trade.

For example, the lowest cost for trading 100 shares of stock we found in a survey of the major online brokers was $7 per trade and the highest commission for the same trade was $15. However, if you needed to talk to a broker to execute your trade the low cost leader would charge you $27 while the higher commission broker would talk to you for free.

The commissions for mutual funds and options were also more expensive with the “low cost” leader. This additional information could easily shift the balance depending on what kind of investor you are.

The bottom line for these “comparison” tables is that they are highly footnoted, biased and don’t reflect your needs as an individual. The best course of action is to completely ignore them the same way you would toss a piece of junk-mail.

On the bright side we feel that there is a logical way to evaluate a broker’s commission schedule in a meaningful way but it requires a little effort on your part:

  1. Evaluate and record your typical trading needs and size

    Create a list of the types of trades you execute (or would like to execute), the typical size of those trades, and your trading frequency. Call the brokers you are evaluating and ask each of them to quote to you how much commissions they will charge based on your list of typical trades. They want your business so make them work for it. Evaluate broker commissions based on your own behavior rather than a piece of advertising.

  2. Ask for lower rates or other concessions

    Keep in mind that most brokers are showing you their advertised or “rack rates.” They may be willing to discount their rates for you and will frequently match the rates you want from another broker to get your business. The point is that you won’t get what you don’t ask for and this may allow you to match the commissions you want with the broker that has the tools, products and service you prefer.

  3. What are the other fees?

    Brokers publish commissions and fees in long disclosures. These are boring and are once again too general to be very useful. Now that you have a quote for the commissions that relate to you specifically you are more prepared to find out what other fees will be charged against your account.

Some of the fees you should look out for include inactivity fees, monthly or quarterly minimums, transfer fees, margin costs and the fees associated with calling a broker on the phone.

As an individual investor you can’t control the market or your returns. This makes it absolutely critical to maximize your control where you can. Trading costs are a key area to evaluate when choosing a broker and once you know what to look for it really isn’t all that difficult. A little effort on the phone can save you a lot of money.

 

Image courtesy Ben Fredericson.

Trading Covered Calls

Option traders frequently start their trading career as options buyers. That can be a great strategy when executed properly but time value works against you. When you are an option buyer, you have to be right about market direction and about the amount of time it will take the market to move. But did you know that it is possible to be on the other side of the trade as well?

[VIDEO] Trading Covered Calls: Part 1

[jwplayer player=LMv2 file=http://d3k2o0dtpg7ker.cloudfront.net/LMOcoveredcalls1.flv” poster=”https://learning-markets-images.s3.amazonaws.com/coveredcalls-videoimage.jpg”]

An options writer sells, or “writes” the option contract that option buyers are paying for. By creating the option, the option seller is taking on the opposite responsibilities of the option buyer. If the option buyer wants to “exercise” their option, you as the seller will need to deliver on the contract. That gives the writer an obligation to deliver.

For example, imagine you want to sell a call. The transaction is relatively simple. You would anticipate being paid the bid price or “premium” for the sale and now you have the obligation to deliver the stock if the option buyer exercises his option.

There are some distinct benefits of selling options:

  1. You get paid your potential profits up front in the form of the option’s price or premium.
  2. If the option expires out of the money, which most options do, then no one will want to exercise the contract and you will keep your entire premium.
  3. As time value melts, the decline in the option’s value reduces your liability and risk as the options seller. Because you already sold the option for a high price and took the premium, you can later buy it back for a cheaper price as time value melts, allowing you to exit the trade any time you like.
  4. You can close your trade at any time. All you need to do is to remove the obligation by buying the option back and washing out the trade. This can be done on the open market at any time.

There is, however, risk with selling options that needs to be controlled. If you sell a call, you have the responsibility to deliver the underlying stock if prices rise and the option is exercised. You can see this graphically in the chart below.

If you had sold a call in April on Google (GOOG) below, with a strike price of $450 per share and the stock gapped up (like it did later in the month, to $550), you are still responsible to deliver the stock to the options buyer for $450. That means you will lose $100 per share as you buy the stock on the open market for $550 to deliver it to your options buyer for $450.

GOOG April Call Example
GOOG April Call Example

The good news is that this risk can be controlled, and is partially offset by the premium you were initially paid. Once they are netted out, these losses may not be as much as you think. I am using an extreme example of a large gap to make the point that options selling does not need to be scary. In the video above we will look at how this trade worked out.

Covered Calls Strategy

In this section of this lesson we will discuss the covered calls strategy, to illustrate how you can further protect yourself from these disadvantages while still retaining the benefits of being an option writer.

The core principle of writing covered calls is that you are controlling risk and attempting to improve returns on a stock or ETF that you own. You can do this by selling a call option against that stock or ETF and collecting the option premium. A covered call consists of a two step process that is easy to implement by new and experienced investors alike.

[VIDEO] Trading Covered Calls: Part 2

The first step in writing a covered call is to be long the underlying stock or ETF. Sometimes investors are selling a covered call against a stock they may have owned for a long time and other times an investor may be buying the stock and selling the call option at the same time, which is sometimes called a “buy-write.”

The second step in writing a covered call is to sell a call against that long stock or ETF position. There are several factors to consider when you are selling the call including, expiration date, strike price and premium. Let’s walk through a case-study of a covered call to begin answering these questions.

Imagine you own 500 shares of Apple (AAPL) and you want to sell 5 call contracts to make some income from those option’s premiums. That trade is a covered call.

The covered call is “covered” because you already own the stock. If prices rise and the call buyer wants to purchase the stock, you have the ability to fulfill on the contract without going to the open market because you already own the stock. This alleviates the problems with selling a call alone as discussed in part one of this series.

Let’s assume you had owned 500 shares of AAPL in late March 2008 when the stock was priced at $140 and sold a call against it with a strike price of $145 and a premium of $6.00 per share or $600 per contract.

As the seller, you were paid $600 of premium per contract for 5 contracts of AAPL calls you sold, for a total of $3,000. That sounds good so far – you made three grand.

However, let’s now look at what happened to those options you sold at expiration, when that obligation to deliver the stock was due.

By April’s expiration the stock was priced at $155 per share and the call buyer wants the stock. She has the right to buy it for the strike price of the calls, or $145, as detailed above you already own it and your broker would just take it out of your account automatically.

You bought the shares of AAPL for $140, so by selling it for $145, you made an additional $5 per share, or $2,500, plus you keep the premium for the calls of $3,000. A good profit, but the downside of the option is that by selling the right to buy at the $145 strike price, you missed out on another $10 per share on the rise in the price of the underlying stock.

The advantage of owning the stock was that is protected you from the liability created by the big breakout in April. Otherwise you would have been responsible for acquiring the stock on the open market for $155, which you would have had to sell for the $145 strike price. The difference is substantial, in that the covered call was a profitable trade, whereas just writing a call without owning the stock would have resulted in a loss.

The advantage of selling the call is not as evident when the market is rising but really comes into play when prices drop. Selling the call and earning the premium provided $3 per share of protection against losses. This protection has the effect of reducing account volatility and improving returns. Over the long run the reduction in losses is well worth the opportunity cost of losing a little upside potential.

AAPL Call Example
AAPL Call Example

In the video above I will look at this situation in more detail and contrast it with other scenarios like when the stock’s value goes down. Covered calls are not only a great way to limit your liability as an option writer but they are an excellent way to hedge risk on your stock holdings as well.

Final Concepts to Keep in Mind

Covered calls, when applied consistently over the long term, deliver significantly lower account volatility without decreasing profit potential. In fact, long term covered call indexes show that account volatility is reduced and returns are increased. A covered call is one of the very few ways to accomplish these two objectives at the same time and is a gateway to learning more about using options as an investor.

[VIDEO] Trading Covered Calls: Part 3

As we discussed earlier in this article, during short-term rallies a covered call can sometimes cap profit potential on the underlying stock. This happens because you can only make the premium you were paid when you sold the option plus the strike price for the stock itself. If the stock is running away to the upside you may have made more just holding the stock.

However, if the market breaks to the downside, the option will expire worthless and you get to keep the entire premium because you will not have to sell the stock at expiration. That premium offsets some or all of the losses you might have accumulated on the underlying stock when it dropped.

Over the long term the reduction in losses more than offsets the opportunity cost of limited gains when the market really takes off.

When you net out the affects of capped gains and hedged losses with covered calls, the end result is a strategy that can reduce the ups and downs of your portfolio but still deliver great returns. In the video, we will look at a classic illustration of this concept that can be monitored in the market every day.

There are a few final concepts to keep in mind as you become a covered call investor.

  1. Be careful about commissions if you buy the stock and sell the call at the same time, this trade is called a buy-write. Call your broker and talk to them about this order type and any restrictions or additional costs they may have.
  2. Covered calls require the lowest level of options trading approval from your broker. Call and make sure this is something you have permission to do in your account.
  3. You can exit a covered call at anytime. If you want to get out, all you need to do is buy the call back at the current ask price and sell the stock.
  4. Many traders will choose to exit a call that has moved in the money that could be exercised at expiration to avoid having to sell the stock they own in their account. There is nothing wrong with this; it is really up to you. It can avoid the hassle and transaction costs of clearing the underlying stock, especially since you’ll often write calls on the same stock over and over.
  5. There are a lot of options writing and covered call “advisory services” promising huge returns. These are seldom true and may come with big fees and lots of account volatility. If you see promises or examples of huge monthly returns from covered calls, be careful; you are probably not getting the whole story.

Understanding Call Options

Call options gain value as a stock’s price increases. Option traders will buy calls when they think the underlying stock or index will move up. One of the most obvious advantages of a call option is that it is much cheaper to buy than buying the stock itself. However, like all options, you have to plan your trade to make sure you are not taking on too much risk.

[VIDEO] Understanding Call Options

A call option gives you the right to buy the stock for the strike price. In the chart below you can see Oracle Corp (ORCL) beginning to break out of a consolidation range in the direction of the prior positive trend.

In this case, you could have purchased a call option (ideally with a strike price as close to the current stock price as possible to take advantage of higher prices in the future).

Oacle Example - June 22 Call Buy
Oacle Example - June 22 Call Buy

In this case, the closest strike price to the stock’s price of $21.67 is $22 which would have given you the right to buy the stock any time before expiration for $22 a share. This call option would have cost you $.75 a share or $75 per contract. Expiration was June 20th, 37 days into the future.

Many traders assume that you must hold an option until expiration before harvesting profits. This is not the case. The call option itself will rise in value as the price of the stock moves, and you can sell it at any time before expiration and collect profits.

Going back to our Oracle example, as you can see in the chart below, the stock subsequently reached $23 a share, and by that time the option had increased in value to $1.05. That has created a profit of $.30 per option share, or $30 per contract, or an ROI of 40%.

  1. Bought 22 call on 5/13: $75
  2. Sold 22 call on 6/4: $105
  3. Profit: $30
  4. ROI: 40% ($30 / $75 = .40)
Oracle Example - June 22 Call Sell
Oracle Example - June 22 Call Sell

There are three things that you should learn from the example above. First, you can buy and sell an option contract whenever you want. You do not need to wait for expiration. Second, a call option’s value will rise and fall with the stock’s price. Third, the option’s price did not increase the same dollar amount as the stock. In this example, the stock’s price moved from $21.67 to $23 for a total gain of $1.33. However, the option only increased by $.30.

What causes an option’s price to grow at a slower pace than the stock’s is a factor called time value. In the video, we will talk about how time value works in the option market and why it is something you need to understand and plan for.

 

Image courtesy James Sarmiento.

The Options Chain Sheet

Options are most frequently quoted in a list format called a “chain sheet.” Each chain sheet has several components and although they are not complicated but it would be helpful to walk through each section so you understand what to look for when evaluating an option trade.

[VIDEO] The Options Chain Sheet

In this article, we will be using a typical chain sheet for the stock Microsoft Corp (MSFT) for demonstration. Keep in mind that every online broker uses a slightly different version of a chain sheet. However, they are similar enough that it is usually not a challenge for a trader to shift from one version to another.

Each element of the chain sheet are described below. The numbers reference each element’s position on the image below.

The Options Chain Sheet
The Options Chain Sheet

Calls and puts (1)

Chain sheets are arranged with calls on the left hand side of the list of options and puts on the right hand side. In some chain sheet versions, the calls and puts are in a single list but the format below is more common.

Strike prices (2)

The available strike prices are listed down the center of the chain sheet. There is a call and a put contract that correspond to each strike price. If you need some help understanding what a call or put is, click here first.

Bid and ask (3)

Each call and put at every strike price has a listed bid (sell price) and ask (buy price). These prices are quoted per share, which means that you need to multiply it by the number of shares per contract, or 100. That will tell you how much a single contract will cost to buy, or is worth to sell.

Open interest (4)

The number of contracts of a call or put at a specific strike price currently held by other investors.

Volume (5)

The number of contracts of a call or put at a specific strike price bought and sold today.

Extra info (6)

Depending on your broker, there may be several other columns for each option contract. This extra information may include last trade price, implied volatility or some of the option Greeks. The most critical information, however, is contained in items 1-5 of the chain sheet.

Understanding Put Options

Put options are the opposite of calls. Using puts, it is possible to invest and benefit from declines in the stock market or in individual stocks – without ever owning them. When you buy a put you are forecasting that the stock’s price will fall in value before the put’s expiration date.

[VIDEO] Understanding Put Options

Buying puts is often compared to shorting a stock. But, although they are both bearish positions, buying puts is quite different. In fact, buying a put can be better than shorting the stock itself because your risk is limited to the amount you paid for the put option.

If the market falls, both trades would be profitable but if the market rises, your risk in a short stock trade is theoretically unlimited.

The process of buying a put is relatively simple. Typically, you want to find a stock in a firm downtrend that you feel is likely to remain in a downtrend. Once you have selected your “bearish” stock, buying a put works the same way as buying a call.

In the chart below, you can see that the iShares Russell 2000 ETF (IWM) had been stuck in a dramatic downtrend and by mid-Feb was bouncing back down from a resistance level at $73 after a brief rise in January. This was a great candidate to for a put trade.

IWM Example - Feb
IWM Example - Feb

Running through a very similar trade entry process that I discussed in the calls lesson, we would start with buying a put with a strike price closest to the current stock price. Since the stock was currently priced at $70.18 the 70 strike with about 30 days left before expiration looks like an ideal candidate.

The 70 put would have cost $2.60 a share or $260 per contract on February 14. In the chart below, you can see the stock subsequently dropped significantly, to $65 by March 10. Assuming that you exited your trade by at that time by selling the put at market value, for $3.70 a share or $370 per contract, you would have harvested a nice profit of $110 and a return of 42% in less than 30 days.

  1. Purchased 70 put on Feb 14: $260
  2. Sold 70 put on Mar 10: $370
  3. Profits: $110
  4. ROI: 42% (110 / 260 = .42)
IWM Example - March
IWM Example - March

As with call options, you have the ability to buy and sell put options before expiration. A put option will rise in value as the stock drops and will decline in value as the stock rises. This gives you the flexibility as an option investor to take advantage of a volatile stock market.

In the video below we will review how time value affects the growth of a put trade. We will also discuss the impact of increasing the time before expiration on the price of a put. There will be times, as a trader, that you will want more than 30 days before an option expires but this will change the price of the option and is something that you will want to plan for.

 

Image courtesy James Sarmiento.

Using Option Greeks: Implied Volatility

In my opinion implied volatility (IV) is the most useful of the option greeks. Implied volatility can be used to adjust your risk control, trigger trades and in a future video I will show you how you can actually trade options on the market’s own implied volatility level. Implied volatility is relatively simple to understand but it hard to predict. It changes as investor sentiment changes and can be very sensitive to the overall market environment. In this series we will be talking about IV and how it can be used to forecast market direction and make trading decisions.

[VIDEO] Using Option Greeks: Implied Volatility, Part 1

Implied volatility is a measure of what investors think about future volatility. This means that it reflects what traders “think” about the potential for the underlying stock or index. That information is extremely useful when you can see and analyze those changes over time. Implied volatility will rise when traders are concerned about risk or are becoming very fearful. Conversely, implied volatility will fall when investors are very confident or bullish. This matters to option traders because an increase in implied volatility causes a rise in option premiums. That is bad for option buyers but can be good for sellers. When implied volatility is falling and traders are becoming more bullish, option prices fall and being a call buyer may be a better alternative than being a put seller.

In the video above we will talk about how implied volatility changes prices and why this matters to investors.

One of the most useful forms of implied volatility is the implied volatility index of the S&P 500 index options (SPX) usually known as the VIX. In a very real way the VIX reflects the fear of the general population of investors. This can be useful as a way to understand the strength of a given trend and as a way to forecast reversals in the market.

[VIDEO] Using Option Greeks: Implied Volatility, Part 2

The VIX will show the relative risk or fear in the market compared to recent history. Traders will try to identify those points in the VIX when investor sentiment or fear has reached extremes. In the video I will show you several good examples of what to look for to find periods of excessive fear and bearishness as well as too much bullishness. These periods often lead to reversals in the market which is a good time to reduce market exposure and begin looking for new opportunities.

As you can see, in the chart below, one of the things we look for when evaluating whether the VIX or investor sentiment is at extremes is whether or not the index is at the top or bottom of its channel. When the index is at resistance (the top of the channel,) we know that fear is at an extreme and we should be controlling any market exposure to the downside of the market very conservatively. It does not mean that we should automatically become bullish but, it does mean that we will act as prudently as possible to control the risk in any short positions or long puts.

Conversely, the market and traders in general can become over confident. Quite often a bounce off the lower side of the channel can indicate a significant shift in investor sentiment from low risk and growth to high risk and volatility. The channels on the VIX will shift over time but typically stay within a given range, such as the one shown on the chart, for several quarters to a few years.

Implied Volatility and The VIX
Implied Volatility and The VIX

When I talk to traders about the VIX and how to use it to understand what is going on with investor sentiment they will often get very interested in trading the channel it tends to stay within. I also think that is a good idea since channels can be very profitable for traders. However, although there are calls and puts available for traders on the VIX they are unique compared to most calls and puts that stock option traders are used to. In order to make this article about implied volatility as practical as possible I think a discussion about how to trade options on the VIX will be useful.

[VIDEO] Using Option Greeks: Implied Volatility, Part 3

1. The VIX options are not based on the index, they are based on the VIX futures.

If you are not a futures trader, this subject may seem complicated but it really isn’t that hard to understand. What you need to know is that the VIX is also traded as a futures contract and there are one of these futures contracts available for each of the next few future months. This means that the current month’s VIX futures contract looks very similar to the VIX index but the futures contract that expires next month may look a little different because it will show what investors think about the market in the next month. Traders may be very fearful of current market conditions right now but they may not be as fearful about where the market will be in a month or two months. That means that the VIX futures contract that expires this month will have a higher (more fearful) reading than next month’s VIX future contract or the month after that and so on.

2. Each month’s option chain sheet corresponds to the same month’s VIX futures contract.

Imagine that today’s reading on the VIX index is 30 and the VIX futures contract that expires this month is priced at about the same level. That is normal and therefore the at the money strike price will be 30. The calls and puts at the 30 strike price should cost a similar amount per contract as you would expect. However, if next month’s VIX futures contract is currently priced at 25 because traders are less fearful about the market next month then the at the money strike prices for next month’s options will be 25 not 30. In the video I will show you how this works and why it can lead to a serious mistake by new traders. Most of the time, your broker’s online trading station will not make this obvious and it can lead to traders drawing incorrect conclusions about the VIX options from one month to the next.

3. VIX options have an unusual expiration date.

Equity traders are used to stock options and index options expiring on or just before the third Friday of the month. VIX options are different and have a very unusual expiration date. Fortunately, you can get an expiration calendar to assist your planning from the CBOE. VIX options expire on the Wednesday that is at least 30 days before the 3rd Friday of the month following the expiration month. Got that? Here is how that works – Imagine that you are holding September 2008 VIX calls. The expiration month for those options is September so we need to find the 3rd Friday of the next month, which is actually October 17th. Counting backwards from October 17th to find the first Wednesday that is at least 30 days prior to October 17th gives us an expiration date of Wednesday, September 17th. We can make the same calculation to determine that October’s options will expire on Wednesday, October 22nd. If that seems complicated just get yourself an expiration calendar and don’t worry about trying to work out the math.

VIX options can be an important part of a well diversified trading strategy. Institutional traders use VIX options to hedge risk and to profit from market uncertainty and fear. The price channel can be easy to identify for a technician and fundamental traders can use them to offset risk as growth begins to slow.

Daily chart of the VIX or "CBOE Volatility Index"
Daily chart of the VIX or "CBOE Volatility Index"