Investing Archives | Page 80 of 221

Aug

2023

Married Put Options Strategy: Defined & Explained

By Mike Zaccardi, CMT, CFA | Growing Wealth, invest, Investing | Comments Off

A married put is an options trading strategy wherein an investor purchases an asset and an at-the-money put to protect against a price drop in the shares.

This options strategy works to safeguard the shareholder from sharp declines in the underlying asset price. You can easily calculate your maximum gain, maximum loss, and breakeven with a married put strategy.

What Is a Married Put?

A married put is an options strategy in which you simultaneously buy shares of an asset and purchase an ATM put to protect against a decline in the asset price.

You might execute a married put strategy when you are concerned about a large downward move in the asset price over the short run, but you want to own the asset for a longer timeframe.

Recommended: How to Trade Options

How Does a Married Put Work?

A married put works by protecting the investor from a decrease in the price of an asset. With a married put, you are still exposed to a loss, but losses are limited based on the strike price of the put option purchased.

At the same time, a married put allows you to participate in upside in the underlying shares since the most you can lose with the put option is the premium paid, while your long asset position has unlimited upside.

At the money put options can be expensive insurance. The premium you pay for the downside protection can make the strategy prohibitively expensive. Put option pricing depends on many variables, known as the options Greeks. A married put options strategy can work well with low-volatility stocks if you are worried about upcoming bad news on the company.

Maximum Profit

One of the main advantages of a married put options strategy is that you retain unlimited upside potential since you are long the asset and the most you can lose on the put option is the premium paid.

Maximum profit = unlimited

Breakeven

A married put’s breakeven is a straightforward calculation. It is the price you paid for the asset plus the premium paid to acquire the put option. The asset must rise by more than the amount of the premium for the strategy to exhibit gains.

Breakeven = Cost basis of the asset + premium paid

Recommended: Call vs. Put Options: The Differences

Maximum Loss

This is where the married put strategy really shines. The maximum loss is the cost of the asset minus the put option’s strike price, plus the premium paid. The most you can lose with a married put is limited.

Maximum loss = cost basis of the underlying asset – strike + premium paid

Finally, user-friendly options trading is here.^*

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

*Check out the OCC Options Disclosure Document.

Married Put Example

It is helpful to run through a married put example to show the benefits and downsides of this options strategy. This can help when comparing it against other options strategies.

Let’s say you want to own shares on XYZ stock currently priced at $100. You buy 100 shares for a total of $10,000 and an at the money put option contract for $5. Each option contract covers 100 shares, so the total premium is $500.

Your breakeven is $105. That is the per share cost of the stock plus the premium paid. If the stock is unchanged at the expiration of the options contract, you will have a loss of $5 on the strategy.

Your maximum profit is unlimited since the stock has no upside cap. If the stock rallies to $120 by expiration, you have a $15 gain. While the maximum profit is unlimited, it will be lower than if you’d purchased only the shares due to the cost of the put.

Your maximum loss is $5, the put option premium. In this example, your maximum loss occurs at or below a $95 stock price. You can close the trade by selling the stock and selling-to-close the option. Alternatively, you can sell-to-close the put or let it expire and continue to hold the stock.

Note: The calculations above disregard transaction costs, but due to the purchased puts being at the money these costs can add up.

💡 Quick Tip: Options can be a cost-efficient way to place certain trades, because you typically purchase options contracts, not the underlying security. That said, trading options online can be risky, and best done by those who are not entirely new to investing.

Pros and Cons of Married Puts

Pros	Cons
Offers downside protection	The put option’s premium might be prohibitively expensive
Offers upside participation	Commissions could be high on the put option
Works well on low volatility assets when you believe is a near-term risk of a share price decline	Liquidity on the put option could be weak

Married Puts vs Covered Call

Married Puts	Covered Call
Purchase an at the money put and the underlying asset simultaneously	Sell a call on an asset you already own
Long the asset and long a put option	Collect a premium to enhance a portfolio’s yield
Exit the trade by selling shares and selling-to-close the put option	Roll out by buying-to-close and then selling-to-open another call.

Strategies Similar to Married Puts

There are several options trading strategies similar to married puts. Let’s investigate those.

Protective Puts

A protective put strategy is very close to a married put strategy. The difference is that you already own the asset with a protective put trade. With a married put, you simultaneously buy the asset and put.

Long Calls

A married put behaves the same way as a long call. You own the asset with a married put strategy, but a long call position does not entail owning the underlying shares. Long calls differ from naked calls since you buy-to-open a call option contract in a long call strategy while you sell-to-open calls without owning the underlying shares in a naked call play.

Call Backspreads

A call backspread is a bullish options strategy wherein you sell lower-strike calls and a greater number of higher-strike calls at the same expiration on the same asset. A call backspread offers unlimited upside. You would execute this complex options strategy when you are extremely bullish on a volatile asset. Call backspreads are also known as ratio volatility spreads.

The Takeaway

A married put options strategy is when you purchase an at the money put option and shares of the underlying asset simultaneously. It is a way to limit risk when you want to own shares in a company.

Qualified investors who are ready to try their hand at options trading, despite the risks involved, might consider checking out SoFi’s options trading platform. The platform’s user-friendly design allows investors to trade through the mobile app or web platform, and get important metrics like breakeven percentage, maximum profit/loss, and more with the click of a button.

Plus, SoFi offers educational resources — including a step-by-step in-app guide — to help you learn more about options trading. Trading options involves high-risk strategies, and should be undertaken by experienced investors.

With SoFi, user-friendly options trading is finally here.

FAQ

Is a married put the same as a covered put?

A covered put is the opposite of a married put in that you are short the asset and short a put option in a covered put trade. With a married put, however, you buy the put and the asset at the same time.

Is a married put a good strategy?

A married put can be a good strategy if you want insurance on a new asset position. It is a bullish strategy used if you are worried about potential near-term risks in the asset. By owning a protective put, you have downside protection while still being able to participate in asset price appreciation. You have the right to receive dividends and participate in shareholder votes by owning the stock, too. The downside is that you must pay a premium to own the put option.

What is the difference between puts and calls in options trading?

Puts and calls are two option types. Puts give the holder the right but not the obligation to sell shares of an asset at a specific price and at a specified time. Calls give the holder the right but not the obligation to buy shares of an asset at a specified price and time.

Photo credit: iStock/Renata Angerami

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Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

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Aug

2023

What the Binomial Option Pricing Model Is & How It Works

By Mike Zaccardi, CMT, CFA | Growing Wealth, invest, Investing | Comments Off

The binomial option pricing model is a valuation tool that predicts the price of an asset for selected future points in time then uses an iterative approach to work backwards to determine the present value of options on that underlying asset.

The binomial option pricing model has the benefit of being relatively easy to implement and provides visibility into the linkages between the underlying asset price and the option prices as the expiration date approaches.

What Is the Binomial Option Pricing Model?

The binomial option pricing model is a widely used option pricing formula. There are multiple versions of the model, depending on what assumptions the trader wishes to make and what types of options are to be priced.

Fundamentally, the model involves a three-step process:

1. Generate the binomial price tree for the underlying asset.

2. Calculate the options values based on the asset prices for each final node.

3. Calculate the option value at each preceding node.

Recommended: How to Trade Options

Assumptions of the Binomial Option Pricing Model

The binomial option pricing model assumes two possible outcomes: an up or down change in the stock price. While it’s simple in a one-period approach, the model can quickly turn complex over multiple time frames. However, constructing the pricing tree illustrates how an asset’s price changes from period to period.

Another advantage is that the binomial option pricing model can be used to value American, European, and Bermuda-style options. There are adjustments needed to use the binomial model based on which options are being priced. For this discussion, we will focus on American options only.

Other assumptions in the model discussed herein include that the underlying asset pays no dividends, the interest rate is constant, there are no transaction costs, there are no taxes, and that the risk-free rate is constant.

It also assumes investors are risk-neutral.

💡 Quick Tip: If you’re an experienced investor and bullish about a stock, buying call options (rather than the stock itself) can allow you to take the same position, with less cash outlay. It is possible to lose money trading options, if the price moves against you.

How Does the Binomial Model Work?

The binomial option tree is used for finding the current value of an option. This value is equal to the present value of the probability-weighted future payoffs.

Binomial Option Pricing Model Calculations

Let’s dive into calculations for calls and puts. In order to understand how these calculations are made it helps to know the basics of options trading strategies.

Call Options

A call option gives the holder the right but not the obligation to purchase a security at a specific price at a specific time. A call option is in the money when the stock price is above the strike price. A binomial tree’s nodes will value an option at the maximum of zero or its calculated value.

Recommended: How Options Are Priced

When the underlying asset moves up in price, the call option’s payoff (C^up) is the maximum of zero and the stock price (S) multiplied by the up factor (u) and reduced by the exercise price (P_x).

call-options-underlying-asset-moves-up-in-price

When the underlying asset moves down in price, the call option’s payoff (C^down) is the maximum of zero and the stock price (S) multiplied by the down factor (d) and reduced by the exercise price (P_x).

call-options-underlying-asset-moves-down-in-price

The binomial model calculates all possible payoffs, based on these calculations. The final outcomes are then discounted back to calculate the present value.

Put Options

Put options give the holder the right but not the obligation to sell a security at a specific price at a specific time. A put option is in the money when the stock price is below the strike price.

When the underlying asset moves up in price, the put option’s payoff (P^up) is the maximum between zero and the exercise price (P_x) minus the stock price (S) multiplied by the up factor (u).

put-options-underlying-asset-moves-up-in-price

When the underlying asset moves down in price, the put option’s payoff (P^down) is the maximum between zero and the exercise price (P_x) minus the stock price (S) multiplied by the down factor (d).

put-options-underlying-asset-moves-down-in-price

Binomial Model Example

Assumptions

XYZ stock is currently trading at $100 and you wish to calculate the value of a call option with a $105 strike price that will expire in two weeks.

You expect that each week the stock may increase by 10% or decrease by 15%. The risk-free rate is currently 5% and you will be looking for cash settlement rather than delivery of shares. Additionally, XYZ is not expected to pay dividends over the two-week holding period.

You want to view how the option price will move weekly up until expiration and calculate the option value today.

Generate the Binomial Tree

We construct the binomial tree for the prices of XYZ stock.

binomial-tree-step-1-price-tree-generation

At the end of one week (1/52 of a year or 0.02 years) the stock will be priced at either $110 or $85.

After two weeks, (0.04 years) the price will increase to $121 if the price moves up twice in a row. The stock price will be $93.50 if the price moves up then down, or down then up. Finally, if the stock moves down twice in a row the stock will drop to $72.25.

Note that we can create a binomial tree for any time period size and include many more steps at the cost of greater complexity in the calculations.

Calculate Final Option Values

Having forecast the stock price two weeks into the future we can calculate the value of the $105 strike price call option at that time.

The call option will only have value if the stock moves up twice in a row. At that time the shares will be worth $121 and the option will be worth $16.

Stock price – Strike price = $121 – $105 = $16

Work Backward to Calculate Present Values

Before we can perform the present value calculations we need to determine the probability that the stock price, and the call option price, will move along the upward path in the binomial tree during each week.

Fortunately we have all the information we need to calculate the probability based on our initial assumptions. The probability for an up move is:

Where:

• t = the time period in years (1 week = 0.02 years)

• r = the risk-free rate (5%)

• u = up factor ($110 / $100 = 1.1)

• D = down factor ($85 / $100 = 0.85)

Substituting into the equation:

Because there are only two paths at each node the the probability of a down move is:

Given the probabilities and the potential option values at the end of week two, we use the present value calculation to determine the option value for the end of week one.

We repeat this process until we arrive at the value of the call option today.

binomial-tree-step-3-work-backward-to-calculate-present-values

At each step we weigh the final values by their respective probabilities and discount by the risk-free rate using the following equation:

Finally, we arrive at the present value of the call option of $5.82.

Finally, user-friendly options trading is here.^*

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

*Check out the OCC Options Disclosure Document.

Pros and Cons of the Binomial Model

Pros	Cons
Simple to calculate	Difficult to predict future prices and probabilities
Can be used on American options	Assumes conditions that are not seen in real-world markets
Can be used over multiple periods	Complexity grows as more periods are considered

Binomial Option Pricing Model vs Black-Scholes Model

The Black-Scholes model comes to a deterministic result based on the inputs. Its inputs are option variables such as the strike price, the current stock price, the time to expiration, the risk-free rate, and the volatility. While the binomial model is considered path dependent, the Black-Scholes model is path independent.

Widely used in practice and considered accurate, the Black-Scholes model makes assumptions that sometimes arrive at options prices that are different from those seen in the real world.

The Black-Scholes model is considered the standard when valuing European options since the model does not allow for options to be exercised early.

Binomial Option Pricing Model	Black-Scholes Model
Probabilistic approach	Deterministic approach
Path dependent with two possible outcomes at each node	Usually accurate, but output prices sometimes deviate from those seen in the real world
Helpful for American options	Helpful for European options

Binomial Option Pricing Model vs Monte Carlo Model

The Monte Carlo model runs thousands of computer simulations to arrive at a solution. Monte Carlo simulation often includes an array of possible paths — some that show higher ending prices and others that show lower prices.

The computer simulations are only as good as the assumptions used. Analysts can tailor the inputs. Often, historical data is used in Monte Carlo simulations which may lead to results that aren’t applicable.

Binomial Option Pricing Model	Monte Carlo Model
An iterative approach that is path dependent	Based on computer simulations
Less computer intensive	You can tailor the inputs and scenarios
Uses future assumptions, not historical data	Output only as good as the assumptions used

The Takeaway

Due to its relative simplicity and speed, traders often prefer it to the Black-Scholes and Monte Carlo models.

With SoFi, user-friendly options trading is finally here.

FAQ

Who developed the binomial model?

The binomial options pricing model was first suggested by William Sharpe in 1978, but the model’s development is associated with work done by John Cox, Stephen Ross, and Mark Rubinstein in 1979.

Are the Black-Scholes and binomial option pricing models the same?

No, these are two different models. The Black-Scholes model provides a numerical result based on inputs. The binomial options pricing model prices an asset based on a range of possible results. The binomial model is considered an iterative calculation since there is a range of possible outcomes to value options. The Black Scholes model uses fixed inputs to arrive at an option’s value.

How is the binomial option pricing model different from the Monte Carlo model?

The Monte Carlo model runs thousands of computer simulations to eventually arrive at an options price. The model first generates a random number based on a probability distribution. That number then uses additional option inputs like volatility and time to expiration to generate a stock price. The stock price at expiration is then used to calculate the value of the option. The result is only as good as the inputs used.

The model runs that process thousands of times, using different variables from the probability functions. To determine option pricing, the Monte Carlo model uses the average of all the calculated results.

Photo credit: iStock/David Petrus Ibars

Aug

2023

Forex vs Options Compared and Examined

By Mike Zaccardi, CMT, CFA | Growing Wealth, invest, Investing | Comments Off

Foreign exchange trading, also known as forex or FX, is a global marketplace where participants trade national currencies.

Options trading allows participants to benefit from asset movements by trading puts and calls with less cash outlay than required to buy the underlying asset.

Both markets are characterized by the use of leverage with many other similarities as well as differences, and traders often engage in both markets.

What Is Options Trading?

Options are financial contracts that give the holder the right but not the obligation to buy or sell an underlying asset at a predetermined price and time, while creating a potential obligation for the option seller to buy or sell the underlying asset (if and when the buyer exercises the option contract).

Calls and puts are the two option types. Calls are the right to purchase an underlying asset while puts are the right to sell an underlying asset.

Options can be found on stocks, exchange-traded funds (ETFs), and on futures. With options trading vs. forex, an important distinction is that the options market is a derivatives market.

Recommended: Guide to Trading Options

Options trading online has increased in popularity now that commissions are so low. There has been huge growth in this market. Drawing traders to options is the potential for big profits over a short period. With options, you gain beneficial ownership of a large amount of an underlying security, like a stock, with a small amount of capital.

Some investors use options to protect their long-term holdings, such as a long stock position, by purchasing puts when they believe a near-term dip might take place. You can also increase your portfolio’s income by selling covered calls.

Overall, options trading can provide protection, generate income, and offer leverage. But options also come with risks.

When comparing options vs. forex, options trading can be more versatile than forex due to the vast number of options strategies. With forex trading, you simply go long or short a currency. Options trading offers the chance to profit in a variety of market conditions, too.

One downside to options trading is that it can take a long time to learn the ins and outs of options trading. Another drawback is that many options are illiquid, so it is hard to buy and sell quickly at a competitive price.

Finally, user-friendly options trading is here.^*

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

*Check out the OCC Options Disclosure Document.

What Is Forex Trading?

Forex trading is the buying and selling of national currencies in a 24-hour market. In general, the forex market is considered the most liquid market in the world. While many currency pairs feature strong liquidity, there are still some that do not have a lot of buyers and sellers.

Trading forex vs. options often involves higher leverage and volatility risks.

When looking at forex vs. options, forex often offers more leverage. That means brokers allow you to trade with more capital than you have deposited in your account. With leverage comes the potential for massive gains, but also the risk of steep losses.

Brokers want to keep your risk in check, though. They often do that by requiring forex traders to enter stop-loss orders immediately once they take a position.

Another aspect that can make brokers nervous is volatility. The forex trading market can feature periods of relative calm followed by explosive volatility. When volatility strikes, currency pairs can become less liquid, leading to difficulties when attempting to exit trades. Forex options can be used to profit from volatility, however.

Comparing Forex vs Options

Let’s dive into some of the key similarities and differences in forex vs. options. It can help you decide which trading arena might suit your style better.

Similarities

A key similarity is that supply and demand drive both forex and options. If a tremendous amount of bullish sentiment arises, an option or currency pair can skyrocket in value. That can lead to big gains in both markets.

Before you jump into trading, doing your homework is important. In currency and derivatives markets, for every long there is a short, that means there is someone on the other side of the trade losing significantly. Remember always, that “someone” could be you.

Comparing options vs. forex, both offer leverage, but in different ways. Options, depending on the strategy, can allow you to control a large amount of stock with a small amount of capital. In forex trading, you can use margin to trade with leverage. You can even trade with up to 1,000x leverage with some forex brokers.

Today’s technology allows you to access many options and forex markets. That can make researching ideas and deciding on a single trade tough since there are so many tradable assets and strategies.

Both markets are regulated to help protect traders and brokers.

Differences

There are many differences in forex vs. options trading.

Forex involves trading currency pairs while options trading involves buying and selling contracts on an underlying asset. Hence, options are derivatives.

The options market is confined to normal trading hours while forex is a 24-hour market.

A final key difference in options vs. forex is liquidity. Many currency pairs have a large depth of buyers and sellers present, but there might just be a handful of traders in a particular options market.

There are also differences in forex vs. binary options, but you can trade forex binary options which are forex derivatives that pay out all or nothing.

Forex	Options
A 24-hour trading market of currency pairs	Contracts derived from an underlying asset
The most liquid trading market in the world	Trade during normal market hours
Ability to trade on leverage	Used for portfolio protection, income generation, and leverage when trading

Pros and Cons of Forex Trading

Pros of Forex Trading	Cons of Forex Trading
Stop losses help control risk	Losses can occur quickly due to leverage
Easier to trade and learn	Volatility can cause illiquidity on some pairs
Extremely liquid market pairs available	Lower middleman fees

Pros and Cons of Options Trading

Pros of Options Trading	Cons of Options Trading
Can be a highly leveraged play on stocks and other underlying assets	Many options are illiquid, which means high bid/ask spreads
Ability to profit from both price changes and time decay	You might not be approved to trade more complex options strategies
Traders can benefit from volatility spikes	Complex strategies can be difficult to learn

Is Forex or Options Trading Right for You?

Your trading preferences drive the decision of whether to engage in options or forex trading. Options offer defined risk strategies, but forex markets are often very liquid and trade 24 hours a day. You can also combine options trading with your stock trading account while forex could provide diversification.

Another market to consider is forex binary options. This market can feature the benefits of both forex and options, but you should always weigh the risks, too.

The Takeaway

There are many similarities and differences in options vs. forex. Options can be used on many underlying assets, and you can define your risk and reward strategy. When trading forex, you can profit from the rise and fall of national currencies and enjoy 24-hour markets. Both markets can be volatile, and there are risks associated with these strategies, so it’s important to recognize that before jumping in.

With SoFi, user-friendly options trading is finally here.

FAQ

Is options trading more profitable than forex?

When analyzing profit potential in forex trading vs. options trading, some contend that there is greater profit potential in the forex market due to very high liquidity and fast execution of trades. A key difference between forex vs. options is that forex can feature tremendous leverage, so huge profits can come quickly, but losses can also result in fast ruin.

Others say that options can be more profitable since this type of derivatives trading offers so many customized strategies that can have defined risk. You can also take advantage of time decay and volatility changes.

Is forex trading less risky than options trading?

It depends on your trading style. When analyzing forex vs. options trading, forex often requires position limits, so that can cap your risk. With options, risk is determined by your trading strategy and the positions you construct and execute. For example, selling a naked call features unlimited risk, but buying a deep in-the-money call can be relatively low risk.

A key difference in options vs. forex is that options markets have a finite time horizon — the option expiration date. Forex trading allows positions to be held longer. Another aspect of forex trading vs. options is that forex trading, despite being a liquid market, can have slippage costs when volatility strikes. That’s a risk to always keep in mind.

How do you invest in forex?

It is easy to start investing in forex. You simply open a brokerage account to hold a foreign currency. From there, you then fund your account, research a strategy, and execute an order. It’s important to always monitor your portfolio as the market can change quickly.

Photo credit: iStock/fizkes

Aug

2023

Guide to Bermuda Options

By Mike Zaccardi, CMT, CFA | Growing Wealth, invest, Investing | Comments Off

A Bermuda option is an exotic option with the defining characteristic of being exercisable on dates that lie somewhere between American and European options expiration dates.

Bermuda option puts and calls can only be exercised at predetermined times negotiated prior to initiation with the counterparty to the options contract.

The exercise terms are less flexible than American options (exercisable at any time prior to expiration) and more flexible than European options (only exercisable on the expiration date).

What Are Bermuda Options?

Bermuda options are exotic options that trade in the over-the-counter (OTC) market. The key difference between more common American and European options is that Bermuda options can only be exercised by the holder at predetermined dates. These exercise restrictions result in Bermuda options being cheaper than American options, but more expensive than European options.

💡 Quick Tip: In order to profit from purchasing a stock, the price has to rise. But an options trading account offers more flexibility, and an options trader might gain if the price rises or falls. This is a high-risk strategy, and investors can lose money if the trade moves in the wrong direction.

How Do Bermuda Options Work?

Bermuda options work similarly to how standard American and European options function. Recall that when trading options there is a buyer and seller.

The call option buyer, also called the holder, has the right but not the obligation to purchase an underlying asset at a pre-specified time and price. The put buyer similarly has the right to sell.

American options can be exercised at any time, whereas European options can only be exercised at expiration. However, with Bermuda options the holder negotiates the exercise dates for the option and these dates are outlined in the contract.

It is common for a Bermuda option to have an exercise date just once per month and at the option’s expiration date. Bermuda options are considered a restricted form of an American option, but you can think of them as a middle ground between American and European options — hence the term “Bermuda”, a not so subtle reference to the island lying between the two regions.

If a Bermuda call option holder wishes to exercise early, they can use specific dates to do so. Bermuda options are typically cash-settled, which means that it is uncommon to exchange the underlying assets. Rather cash is exchanged based on the difference between the current market price of the underlying asset and its strike price.

Finally, user-friendly options trading is here.^*

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

*Check out the OCC Options Disclosure Document.

Pros and Cons of Bermuda Options

Bermuda options are considered “exotic” options which means they are typically reserved for the sophisticated and experienced options trader. As such, traders should become familiar with the many pros and cons of Bermuda options. You might find that you are more comfortable sticking to the more common American and European options.

Pros of Bermuda Options

Bermuda options are usually less expensive to buy compared to American options due to the exercise restriction placed on the buyer. American options exercisable at any time through expiration trade at a higher premium due to this flexibility.

For sellers, Bermuda options can bring in more premium than writing European options since European exchange-traded options can only be exercised on the expiration date.

If you are looking for customized approaches to your options trading strategies, then Bermuda options could be a good choice in contrast to the more common two categories that are standardized.

Multinational companies might seek Bermuda options to hedge their foreign currency exposure. A U.S. firm that receives payment in another country must convert funds to dollars. That corporation can reduce its option premium cost by using Bermuda options instead of American options and align the options exercise dates with the relevant transactions they are hedging.

Cons of Bermuda Options

In contrast to American and some European options, Bermuda options trade through the OTC market in bilateral deals. The OTC market often features wider bid/ask spreads compared to trading through options exchanges.

Of course, only being able to exercise once per month may not be ideal for the active trader.

Moreover, Bermuda options are pricier than European options, so if you plan to hold through expiration, then owning European options can save on premium costs.

Pros	Cons
Less restrictive compared to European options	More restrictive compared to American options
Cheaper than American options	More expensive than European options
Helpful for large multinational firms that face foreign currency exposure and risk	Trade through the less liquid OTC market

Bermuda Options vs American Options

Bermuda options are different from American options due to their more restrictive exercise periods. The option to exercise at any time through expiration is a key benefit for a holder, so American options are generally more expensive than Bermuda options.

American options are likely the most well-known category of options and many trade through exchanges like the Chicago Board Options Exchange (CBOE) instead of the OTC market resulting in better price discovery and liquidity.

American options can be priced using the Black Scholes option pricing model, but Bermuda options cannot be priced that way.

Also, most brokers do not allow you to buy options using margin, or borrowed funds. You should check with your broker and weigh the pros and cons to determine if it’s a good idea to margin trade.

Bermuda Options vs European Options

The key difference between Bermuda options and European options is that the former can be exercised during specific times in the life of the option. European options are only able to be exercised on the day of expiration. The added flexibility of Bermuda options makes them more expensive.

American Options	Bermuda Options	European Options
Most expensive due to the high degree of flexibility when exercising	Less expensive than American options but more expensive than European options	Least expensive since they can only be exercised at expiration
Often used by retail traders with stocks and exchange-traded funds (ETFs)	Commonly used by institutions seeking to hedge currency or foreign interest rate risk	Many index options are settled as European style
Traded on exchanges and are standardized	Traded through bilateral OTC markets and can be customized	Traded mainly through OTC markets with some index option listed on exchanges

Bermuda Options Example

It helps to walk through a Bermuda option example to better grasp how it functions.

A trader wishes to buy a Bermuda call option that expires in three months from now on shares of XYZ stock that currently trades at $100 per share. The strike price is $110 and the premium is $5. The contract terms state that exercising can only take place on the first business day of each month.

The following month, the stock price jumps to $120 and the option price is $12 with a bid/ask spread on the OTC market of $10/$14. The trader chooses to exercise early rather than receive the bid price.

It’s important to recognize that as with other options, exercising early is not always the most profitable choice when trading options.

The Takeaway

Bermuda options can provide a cheaper alternative to American options with the trade-off of restrictive exercise terms. However, be aware of all of the pros and cons before pursuing this exotic options strategy.

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FAQ

Why are Bermuda options called that?

Bermuda options got the name because its characteristics lie between those of American and European options — much the way the island of Bermuda lies between America and Europe. Bermuda options can only be exercised on specific dates. American options can be exercised at any time while European options can only be exercised at expiration.

How are Bermuda options priced?

Bermuda options are priced similarly to other options, but the premiums tend to be lower than American options since the holder can exercise them only at predetermined periods. The cost of a Bermuda option is typically more expensive than European options. Complex option pricing models are necessary since the Black Scholes option pricing model cannot be used on Bermuda options.

How rare are Bermuda options?

Bermuda options are rare compared to common styles like European and American options. A Bermuda option is considered an exotic option category that usually features an optionable date in one-month increments. Bermuda options are so rare that they are traded bilaterally in the OTC market, not through an options exchange.

Photo credit: iStock/PeopleImages

Aug

2023

What Is a Donchian Channel? Definition and Example

By Mike Zaccardi, CMT, CFA | Growing Wealth, invest, Investing | Comments Off

Donchian channels are used to identify an asset’s volatility, price breakouts, and breakdowns. The Donchian channel strategy helps traders identify overbought or oversold conditions of an asset.

In general, traders use Donchian channels to identify bullish momentum breakout stocks to go long and bearish breakdown stocks to go short. Donchian channel breakouts occur when the asset’s price is above the channel high. Similarly, Donchian channel breakdowns occur when prices move below the channel low.

Donchian channels are easy for beginners to grasp and flexible enough to be applied to charts of forex products, stocks, options, and futures. Donchian channels are most effective when used together with other technical indicators to filter out noise and confirm trading signals.

What Are Donchian Channels?

Donchian channels help traders by displaying a security’s price volatility, potential trend breakouts and breakdowns, and possible overbought and oversold conditions.

Three lines are used to construct a Donchian channel. The channel high (upper band) is the highest price of an asset over a given time period. The channel low (lower band) is the lowest price over a given period.

The center line is simply the average of the high and low channels.

Traders can select any lookback period, although 20 periods is typical. Candlestick charts are often used when Donchian channels are applied as they enable better identification of channel crosses than line charts.

Donchian channels also have the flexibility to be used on a variety of asset types including options. If you are a beginner looking to trade options, this is a strategy to consider.

💡 Quick Tip: Look for an online brokerage with low trading commissions as well as no account minimum. Higher fees can cut into investment returns over time.

How Does a Donchian Channel Work?

Donchian channels work by helping you find stocks that are potential candidates for bullish breakouts and bearish breakdowns.

This indicator works similar to Bollinger Bands, but Bollinger Bands are less sensitive to big high or low prices and use a security’s standard deviation to form its bands. Additionally, breakouts identified by Bollinger bands identify trend reversals whereas breakouts of Donchian channels identify new trends in the same direction.

While the bands of a Donchian channel can be seen as potential support and resistance, traders often use this technical analysis indicator to spot momentum entry prices on a stock. For example, you might enter a long position when a share price breaks through the channel high. You can also use the Donchian channel to find short stock candidates — those with breakdowns through the channel low.

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Donchian Channel Strategy

The Donchian channel lines help a trader develop support and resistance areas on a chart. This indicator is often used with others to form a trading strategy.

While a 20-period setting is often used, Donchian channel trading can be used with any timeframe. Some strategies use four- or five-week periods. A common Donchian channel strategy is to wait for a stock to breakout above the channel high, then buy that stock.

You can also wait for a bearish breakdown through the channel low to short a stock.

With your trading strategy, it is important to know the risks and limitations of Donchian channels. It might be tough to discern if price poking through the channel high is a true bullish breakout or a sign of a reversal without confirmation from other technical indicators.

Recommended: How to Analyze a Stock

Your trading strategy should also be aware of how arbitrary Donchian channels can be — a commonly used n-period value might not be an ideal gauge for market or stock-specific conditions.

False signals can trigger and hurt trading performance.

Donchian Channel Scalping

Scalping is a trading style that seeks to profit from small price changes. Scalping a trade requires quick and strict entries and exit plans. A Donchian channel strategy with scalping is used to make small profits when a stock moves above the channel high: You buy the asset on the breakout, then quickly sell it after it moves higher. You can also scalp by playing reversals off the upper and lower channels.

Donchian Channel Breakout

A Donchian channel breakout trading strategy is used with trend-following plays. Traders can establish a long position when the security is above the channel high and go short an asset when it is below the channel low. A Donchian channel breakout strategy is often used when there is an existing price trend. Stock trading and derivatives trading can employ Donchian channel breakouts.

Reversal Trading Strategy

Traders also use a Donchian channel strategy to help spot reversals. When a stock price falls below the center line, a short position might be initiated to wager on continued weakness.

On the flip side, when a stock rises above the center line, a long position might be made with the hope that the price continues higher. With reversal trading, the position is closed when the price hits the channel low or high.

Pullback Trading Strategy

The pullback strategy is usually very short-term in nature. If you notice that price continues to touch the channel high before falling back, then shorting an asset when it hits the channel high is a viable pullback strategy.

If the security touches the channel low repeatedly, then bounces, going long that stock in a broader uptrend can help you “buy the dip.”

Donchian Channel With Futures

Richard Donchian, dubbed the father of trend following, developed this indicator in the 1950s and originally applied it to commodities trading. Hence, trading futures contracts with the Donchian channel indicator is common practice.

Donchian created this tool as a trend-following indicator. So, it helps to use it on commodities (or other futures products) that are in an existing uptrend or downtrend. A trendless chart can lead to many false signals.

Other strategies can be used to profit from sideways price action including strangling an option.

Donchian Channel vs Bollinger Bands

While a Donchian channel is plotted with the highest and lowest price over n-period along with an average line, Bollinger Bands uses a simple moving average, then applies a two standard deviation upper band and a two standard deviation lower band.

There are key differences between a Donchian channel vs. Bollinger Bands.

Donchian Channel	Bollinger Bands
Uses price highs and lows to mark a channel	Uses dispersion to mark trading bands
Identifies potential new trends	Spots potential trend reversals
Heavily influenced by price extremes	More balanced since a simple moving average is used

Donchian Channels Limits

There are some limits with Donchian channels.

In assets with low floats, where a large proportion of the asset is held by insiders or institutions, channel trading can be ineffective. Low floats tend to correlate with high volatility, therefore, prices can fluctuate to such an extent that channels become less effective indicators.

Calculating Donchian Channels

Calculating the upper limit, lower limit, and center line to form a Donchian channel is straightforward. The below calculations assume a 20-day period.

Channel high line: 20-day high
Channel low line: 20-day low
Center line: (20-day high + 20-day low)/2

Channel High

The channel high is seen as the limit of bullish energy as it is the highest price recorded over the period used. Traders use the Donchian channel high as an indicator to go long a stock based on bullish price momentum.

Stocks breaking out through the channel high are seen as establishing a new upward trend or continuing existing upside price action.

Channel Low

The channel low is the lowest price hit over the period. Stocks that break down below this line are sometimes used as candidates to sell short with a Donchian channel strategy.

Channel Center

The center line identifies the average price over the period. It is the middle ground of price action and is sometimes seen as a mean reversion price.

Example of Using Donchian Channels

To illustrate Donchian channels, here is a one-year stock price chart with Donchian channels plotted. The standard 20-day period (closing prices) is used.

Other Strategies

Donchian channels can be used with other indicators to form strategies with many types of investments.

One strategy is to combine a Donchian channel with the MACD indicator.

Another strategy uses a volume oscillator with Donchian channels to help confirm a breakout or breakdown.

Finally, a Donchian channel can be used alongside a stochastic oscillator and moving average to help find buy and sell points.

Donchian channels can also be used with options trading: learn more about options vs. stocks.

The Takeaway

Using a Donchian channel strategy is just one way to analyze a stock. It is a technical analysis indicator that helps you identify breakouts, reversals, and potential overbought/oversold conditions.

With SoFi, user-friendly options trading is finally here.

Photo credit: iStock/ArLawKa AungTun

Married Put Options Strategy: Defined & Explained

What Is a Married Put?

How Does a Married Put Work?

Maximum Profit

Breakeven

Maximum Loss

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Married Put Example

Pros and Cons of Married Puts

Married Puts vs Covered Call

Strategies Similar to Married Puts

Protective Puts

Long Calls

Call Backspreads

The Takeaway

FAQ

Is a married put the same as a covered put?

Is a married put a good strategy?

What is the difference between puts and calls in options trading?

What the Binomial Option Pricing Model Is & How It Works

What Is the Binomial Option Pricing Model?

Assumptions of the Binomial Option Pricing Model

How Does the Binomial Model Work?

Binomial Option Pricing Model Calculations

Call Options

Put Options

Binomial Model Example

Assumptions

Generate the Binomial Tree

Calculate Final Option Values

Work Backward to Calculate Present Values

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Pros and Cons of the Binomial Model

Binomial Option Pricing Model vs Black-Scholes Model

Binomial Option Pricing Model vs Monte Carlo Model

The Takeaway

FAQ

Who developed the binomial model?

Are the Black-Scholes and binomial option pricing models the same?

How is the binomial option pricing model different from the Monte Carlo model?

Forex vs Options Compared and Examined

What Is Options Trading?

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What Is Forex Trading?

Comparing Forex vs Options

Similarities

Differences

Pros and Cons of Forex Trading

Pros and Cons of Options Trading

Is Forex or Options Trading Right for You?

The Takeaway

FAQ

Is options trading more profitable than forex?

Is forex trading less risky than options trading?

How do you invest in forex?

Guide to Bermuda Options

What Are Bermuda Options?

How Do Bermuda Options Work?

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Pros and Cons of Bermuda Options

Pros of Bermuda Options

Cons of Bermuda Options

Bermuda Options vs American Options

Bermuda Options vs European Options

Bermuda Options Example

The Takeaway

FAQ

Why are Bermuda options called that?

How are Bermuda options priced?

How rare are Bermuda options?

What Is a Donchian Channel? Definition and Example

What Are Donchian Channels?

How Does a Donchian Channel Work?

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Donchian Channel Strategy

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Finally, user-friendly options trading is here.^*

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