The Best Binary Options Trading Software

Trading software is the most important tool that a trader can possess (other than his mind).  You need confidence that your software will be reliable, have low latency (information is as current as possible), and will be easy enough to navigate that it doesn’t cause unnecessary user errors.

Binary Options Software Is Online

Downloading a software program is not required to trade binary options, the trading software is entirely within the online platform.  This makes it easier for the trader because there are not separate programs to load to enter trades.  Simply sign into your account online, and you can begin trading live immediately.  The best binary options trading software is a platform system that is clean, efficient, and simple for the user to learn.  At How We Trade we use Tradorax, because their straight-forward platform really limits any trade entry mistakes a trader may be inclined to make.

Prevent User Errors

Binary options are not necessarily easy to master, but mechanics of trading them are simple, and entering trades needs to be just as straightforward.  Our trading software leaves no excuse for making order entry mistakes.  Order entry mistakes are a trader’s worst nightmare because of how quickly profits increase as a traders winning percentage increases, there is a very thin margin for a trader to make mistakes if they wish to maintain their profitability.  One order entry mistake can cost a trader a fortune if the mistake is large enough.  Using the best software is the easiest way to reduce the probability of making this type of mistake.

We know that Tradorax trading software makes choosing to buy a call or a put extremely easy and clear.  They make it very difficult to accidentally buy a call if you really wanted a put, or vice versa. There is even an order verification options before the trade is actually final (we recommend you keep this option on) so the user always can be confident that they are placing the trade they intend to place before it is final.

Real Time Information (Low Latency)

With their binary options software platform (as with any good software platform) the trader can then track the current price of the underlying asset or security in real time, and easily tell if the trade is in the money.  Multiple trades can be entered and tracked at the same time, and they provide the updated expected payout value as prices move.  Having the lowest latency possible is crucial to a trader’s ability to read a stock and to predict the future outcome with the highest chances of success.  We always recommend that you use low latency software.

Adding And Withdrawing Funds Are Easy And Straightforward

They also allow the trader the ability to withdraw their earnings and balance very quickly, and fund their account very easily.  Using a straightforward system leaves this process relatively stress free for traders, so they can focus on what matters the most, their trading!  There are no hoops to jump through for a trader to add or withdraw money from their account, and a trader has complete control within the online platform.  Always make sure that any broker you use makes accessing funds very easy.  We know that noo one wants to fight to retrieve their own money from their account.

A Reliable Platform

Many software platforms offer very similar functionality, but perhaps the most important feature is the reliability.  Make sure that any binary options trading software you use offers extremely high reliability for their traders.  You do not want the software to crash when you are in the middle of a trade.  We want you to be able to watch all of your trades with the highest precision possible, to free you to make the best decisions that you can make.

Great Client Support

Also make sure the broker you trade with offers a high quality customer support service, who will answer any questions about the software system or trading.  It is paramount that a trader completely understands every feature of the platform before trading, and any reputable broker will be happy to walk a trader through their software.

For these reasons we use Tradorax, but ultimately a trader needs to be comfortable with the software and trust the brokers systems.

Binary Option Trading Tips 2016

what is day tradingBinary options are one of the best ways to make money as a day trader, offering returns of up to 80% on one minute option contracts.  Just like more traditional forms of trading however, a trader is only going to make money in the long run if they have a good strategy and stick to it at all times.  With that in mind, here are the top binary option trading tips from How We Trade.

1. Keep in mind that the only thing that matters is having your contract expire in the money.  You don’t need big volatile moves, focus on the highest probability, most predictable trades.  You only need to be correct by 1 penny, there are no bonus points for winning big here.

2. Develop a strategy with small trades first, and then ramp up your trade size when you can prove your strategy is effective over time.

3.  Never risk more than 10% of your account value on any one trade.  Binary options contracts have huge returns for traders on winning trades, but just like regular option contracts traders lose 100% when a contract expires out of the money.  Never let one trade destroy your account.

4. Always trade with a reputable broker.  Binary options are not under the same regulation as equity trading.  Tradorax is our chosen broker.  They are the biggest and most reputable brokerage.  Trade with them or a similar broker always.

5.Use the S&P500 (ticker SPY) as an indicator for direction for other stocks, especially after 9:45 AM Eastern Standard Time.  Just like we do when we trade traditional equities, we watch the SPY closely because individual stocks move in a very high correlation with the S&P500 index during trading hours.

6. Look for times of low volatility.  Binary Options do not have spreads a trader must make up to have a trade “in the money”.  Just pick the correct direction and you will make a lot of money.

7.The most popular trade is not always the best, look for stocks that you have a good read on direction with, don’t just trade what everyone else is.

8.Concentrate on the securities that works for you, and what you know best.  You don’t need to trade every security being offered. Learn something well and profit from what you learn.

9.Don’t trade between 9:30 a.m. and 9:45 a.m. unless you are experienced, the direction of movement often changes very rapidly during this volatile time.

10.Take advantage of the convenience of binary options.  The short duration of contracts allow you to trade them during a lunch hour, or a free time during the day.  You don’t need to watch a position all day to begin trading.

Here are more resources:

If you would like to begin trading binary options start by opening an account below with our broker.  You do not need to fund your account immediately to open.

Open Binary Options Account Now

Low Deposit Binary Options Accounts

Binary options are a great way for a trader to make a great return, without putting up a lot of capital. Traditional brokerages require minimum funding of $500 or more, and at least $2000 for a margin account. Then they charge you at least $10 per trade, and by the time you pay commissions its very difficult to make a profit with a small account.

Binary options accounts are the opposite. An account can be funded with as little as $100, and there are no commissions on trades.  A trader with a winning trade can make up to 80%, no matter how far in the money the trade is.  You can imagine how quickly profits can add up with a few winning trades.   If you are looking for the most efficient way to trade with a small account, look no further than binary options.

The reason there are no transaction costs is because binary options contracts are not traded on secondary markets amongst third parties. They are only a contract agreement between the trader and the broker. Without third party traders and institutions, it allows for binary options to offer one of the highest average payout percentage of any trading instrument currently on the market. The brokerage makes money when the contract does not expire in the money but if an option trader has a winning strategy the return potential is enormous.

Tradorax is the best binary option broker to trade with.  They make account funding very easy, have extremely low funding requirements, and have some of the highest payouts in the industry.  They are one of the larger brokers by far in the world.  They are also very reputable and we trust their customer service department to satisfy trader needs.

To open an account with Tradorax sign up below:

Volume Weighted Average Price – VWAP

Volume weighted average price (also abbreviated VWAP) is a formula used to calculate the average price a stock trades at, weighted by volume transacted at each price level.  Normally traders are concerned with the volume weighted average price over a 1 day trading period, but some may be interested in longer or shorter term periods.

Day traders may track VWAP because this calculation is very significant to the trading of many mutual funds and most pension funds.  When the current intra-day price varies significantly from the VWAP, there may be pressure for the price to move towards the VWAP.

This calculation is important to large passive institutional investors who are simply trying to match their average transaction price to the average price transacted over the course of a trading period.  By matching the VWAP as closely as possible, they may reduce their market impact costs, which are the costs incurred by large traders whose trades are so large they move prices.  They also reduce the risk that incorrect market timing will result in their average transaction value being significantly worse than what the market as a whole received.

How Volume Weighted Average Price is Calculated

Volume weighted average price is very simple to calculate.  One takes the total value traded over the time period being analyzed, and divides by the total quantity traded.

VWAP =   Quantity of  Shares Bought at Each Price * Price of Each Transaction / Total Volume

Or more simply

VWAP= Total Value of All Transaction / Total Volume

Here is a simple example.

Transaction 1 = 100 shares at $10

Transaction 2 = 300 shares at $10.20

Total Value = (100* $10) + (300*$10.20) = $1000 + $3060 = $4060

Total Quantity = 100 + 300 = 400

VWAP = $4060 / 400 = $10.15

Practically speaking a trader could not keep track of VWAP in real time without computer calculating assistance.  Many charting software packages do include VWAP tracking capabilities.

What is an Exchange Traded Fund- ETF

An exchange traded fund, abbreviated ETF, is a fund that trades like a stock, and tracks an index, an asset class, a commodity, or basket of commodities.  Like a stock, an exchange traded fund will transact throughout the day, and does not necessarily trade at it’s intrinsic value, or net asset value (NAV).  This is unlike a mutual fund, which only trades on market close exactly at the net asset value.

Unlike a mutual fund an ETF is not actively managed, meaning its performance is meant to mimic the underlying asset(s) tracked as closely as possible, either on an intra-day or long term period, depending on the ETF.  Exchange traded funds typically have much lower expense charges than mutual funds, making them attractive to some investors.  ETFs are also attractive to day traders, who can trade an index or commodity with an equities trading account, rather than a futures or commodities account.

Some exchange traded funds are meant to trade double or even triple the volatility of the underlying index or asset tracked.  These funds are solely for the purpose of day trading, and never should be held long term as they have considerable decay in their net asset value.  The reason for the decay is the use of leveraged products to create the extra volatility.  Recently these funds have come under more regulatory scrutiny because by design, they will all eventually be worth $0.  They also create extra volatility in the market as a whole as the funds must rebalance their own assets during the trading day.

While an exchange traded fund is not necessarily required to trade at a share value which would correspond exactly with the true NAV, any significant deviate would qualify as an arbitrage opportunity, and any inefficiencies in pricing are typically rooted out very quickly by high frequency traders.

ETF volume accounts for hundreds of millions of shares of market volume daily, and these products have become very popular amongst both investors and traders.  The most popular ETFs include: SPY (S&P 500), EEM (emerging markets), GDX (gold miners), VXX (S&P 500 VIX), and XLF (Financials).

Sometimes an ETF may be useful to a trader acting on sector specific news, when the trader is unsure how one particular asset within the sector will be affected.  An example is when the US Government decided to increase capital holding requirements of banking institutions.  Without a full analysis of each bank, a trader would not know how significantly each would be affected.  Instead knowing that the industry as a whole would likely decline in price on the news, the trader may have decided to short the XLF (Financial Sector)

Traders and investors alike should educate themselves on exchange traded funds as they provide a useful alternative to other assets.

Market Capitulation: What is it and How to Identify

A common term amongst traders is capitulation.  This term has meaning outside of the trading world, which is basically giving up or surrendering completely.  Applied to trading, this is a common observation during a period of selling, both in long and in short moves.  Simply defined, capitulation occurs when a significant amount of long positions are abandoned, creating a sharp period of selling and price decline.  Capitulation is actually a very intuitive concept, especially when one considers the emotional aspects of capital market trading.  Periods of capitulation also offer one of the most excellent inefficiencies in the market which can be exploited by savvy traders.

Capitulation can mean two ways to make money to a trader who successfully can identify the moments it is taking place.  The shortest term traders understand that taking a short during this period of time is about as close as trading gets to “free money”.  The selling is often so rapid and so fast, that a trader only needs the courage to take a position short, and often the position will quickly be in the money, and remain in the money until the end of the selling.  These traders must understand the moment the selling is over though, because to longer term traders this moment signals an excellent opportunity to buy at an “inefficiently cheap” price. Capitulation most often marks the bottom, or very close to the bottom of a decline in price.

Here is an excellent example of capitulation in GE.  Capitulation occurred on March 4th of 2009.

Capitulation in GE
Capitulation in GE

True capitulation is marked by an extreme increase in volume as sellers are scrambling to exit positions, and not enough buyers are present to control the pace of selling.  Notice the massive spike in selling volume on March 4th, 2009. Notice as well how this marked the exact bottom of the decline in price.  From this point GE went on to more than double in price in only 2 months!  This is obviously not a “day trade” but imagine how much money was made by some traders who identified this final push down as the capitulation point.  The volume uptick coupled with the sharp decline provided a very clear signal that many long positions were selling out.

As more sellers paniced out of their positions, it created more downward pressure on price.  This had the effect of both forcing other long positions to realize their loss before it got even bigger, and making potential buyers step out of the way as the downward pressure was so hard.  The lack of buying meant sellers had an even greater effect on price than they would have during other periods.

At some point the panic selling stops, and buyers realize that the price has moved far from its rational value.  Timed correctly, buyers often have large gains when rational behavior returns and prices move back to more efficient levels.

While this is an example on a very large scale, capitulation can be seen intra-day at points when many traders and trading algorithms are forced out of their positions at the same time by a large seller, and the price falls quickly accompanied by sharp volume to inefficient levels.  For those who identify the move as capitulation it can provide excellent trading opportunities.

What is a Stock’s Volume

Volume is the total quantity of shares which have transacted in a given time frame.  Traders use volume as a measure of a stock’s volatility or potential volatility.  Higher volume will generally signify that a lot of parties are interesting in trading the stock, and the stock is likely to move as a result.  Volume measurements are also used as a signal of liquidity of a security, so a trader can judge his ability to enter or exit a position at current market values.

Higher volumes are generally favorable to traders, but may only be beneficial to a point, or may not be beneficial depending on the exact strategy. A trader may also look at average volume at a daily level, or may even break this down in smaller increments of the day to judge when he may best employ a strategy.

Volume does not double count transactions, meaning if a trader purchases 100 shares from another seller it results in 100 shares of volume, not 200.

Typically in charting software volume is displayed below the price chart.  Volume is normally displayed for every price bar, so that if a chart is displaying 1 minute price bars volume will display for each minute.  The chart and volume together typically will look something like this:

Daily Price Bar and Volume
Daily Price Bar and Volume

This is a daily chart of GE, with the volume displaying for each price bar directly below the bar.  In general it can be noted that days with lower volume also have a smaller range in price.

Volume is NOT an indication of price direction by itself, it simply is a signal that traders use to judge if a stock is likely to move.  Often times traders will watch screens displaying the stocks with the highest volumes, or displaying sudden spikes in volume, which is can be a sign that news was released, or at least that the stock will be moving.

Traders who are relatively new and are working on refining their strategy will be well served to watch how volume impacts trading.

Relative Strength Index- RSI

The relative strength index of a stock is a technical indicator that is used to calculate whether a security is currently in an overbought or oversold state.  This is a very important and fundamental indicator that has been used by traders since it was developed in 1978 by J. Welles Wilder, Jr., an American mechanical engineer who is known for his groundbreaking work in technical indicator development.

Calculation

Relative strength index, or RSI for short, is calculated as follows:

RSI = 100 – 100/(1+RS)

RS= the average of x up days closes (AU)/the average of x down day closes (AD).

AU= sum of previous x days up closes value (SU)/x

AD= sum of previous x days down closes value (SD)/x

X normally is set to a 14 period but users can most often edit this is charting software.

An up day value is calculated as follows:

Current close – previous close= up day value

down day value is assigned as 0 on an up day

A down day value is calculated as follows:

previous close –  current close = down day value

up day value is assigned as 0 on a down day.

Example

Over the previous 14 trading days, stock ABC has a sum of up day values of 20.  During the same 14 day time period the sum of down day values is 10.

AU = 20/14 = 1.4

AD = 10/14 = .7

RS = 1.4/.7 = 2

RSI = 100 – 100/(1+2) = 100- 33 = 77

As you can see a higher relative up day average results in a higher RSI value, while the opposite is true of greater relative down day averages.

A longer time period will result in a calculation that is less sensitive to moves and is more likely to result in RSI values closer to 50, while a shorter time period will result in a more volatile indicator which is more likely to show extreme values.

* It should be noted that current calculations of RSI often use exponential moving averages for AU and AD values.  The math for this is even more complex but essentially results in higher weighting being placed on more recent values.  If you understand this framework the logic behind using exponential moving averages is not hard to grasp, even if the actual calculations are.  It is rare that a trader would actually have to calculate a relative strength index by hand since it is included on almost any charting software.

Application as an Indicator

After obtaining a value from the relative strength index calculation, normally the value is plotted on a graph which is either superimposed over a price chart or placed underneath.  Due to the construct of the RSI formula, values are bound between 0 and 100.  Normally a value of 30 or lower is considered oversold,   while a value of greater than 70 is considered overbought.  Sometimes the thresh hold level is adjusted to 25-75 or even 20-80 to increase the rarity of the indicator threshold being met.  A trader may use the meeting of the indicator with a top threshold to mean a short or sell signal, while the meeting of a bottom threshold may be used as a buy indicator.  Let’s take a look at how an RSI appears on charting software.

RSI under a recent chart of the S&P 500 .
RSI under a recent chart of the S&P 500 .

The S&P 500 has been trending steadily up over this time period, but you can see that even in this strong uptrend oftentimes when the upper 70 level threshold is met short term selling has followed the majority of the time.

While it may not be the only technical indicator a trader uses for entries and exits, every good trader is aware of RSI levels as they are a tried and true method of identifying overbought and oversold conditions.

Searching For Your Trade? How to Find Your Strategy

Developing a strategy when you are a new trader is tough.  Even after you have been trading for a long time, it is very common to develop a dependency on one niche.  You stopped looking at other strategies because what you were doing worked so well, and why waste time and money on stuff that doesn’t work?  Then one day you realize that the trade is gone.  The trade that was once so dependable  now loses money!  Now there is nothing to fall back upon.  Sound familiar? What is a trader supposed to do?

Well the good news is there are always opportunities, it just takes work to find them.  So whether you are a green trader looking to break into the business or a seasoned veteran that needs a fresh perspective, here are my 5 keys to developing your niche.

Keys to Strategy Development

1. The first step is to take a deep breath and clear your head.  Approach the search with an open mind.  Opportunity exists everywhere in the market but you need to be open to it.  Remove anything in your head that says it doesn’t exist or that you can’t exploit it.

2. Start with a very broad perspective.  Look at the market and how it responds to positive news, and how it responds to negative news.  Notice that the reactions are rarely equal in severity.  What is the general sentiment?  What kind of stocks are in the news?  Maybe you notice that small pharmaceutical stocks with drug approvals normally will trade up for 2 days or even longer following the announcement, maybe this is something to keep an eye on.  Maybe you notice that blue chip stocks not in the news follow technical signals to a T for long periods of time.  Start thinking about what is moving and if it can actually be predicted with any reliability.

3. Research strategies people have published.  It rarely works to simply copy a public strategy robotically, but you may see some adaptations that you can profit from.  A great example is how we often use this indicator for trade entries, but only when it meets certain conditions that work for us, and we always use our own exit strategy. The point is to get a boost from what is out there, but adapt it to yourself.  In the same vein:

4. If you are experienced you need to understand what you do well and what you don’t.  Are you great at being aggressive in fast moving trades, in and out in 10 minutes with a huge profit, or do you read a monthly chart and know that at some point in the next week a stock is going to hit that target?  Do you get scared out of positions when you watch them too closely, or are you a master at ignoring the noise? The point is it helps to narrow down the time period that you are analyzing.  Some traders place 10 trades a year and win big on 8 of them, other traders place 20 trades a day and win on 6 of them, but both are capable of making money.

5. Consider other ways to profit from movement.  Maybe if you often get scared out of trades you won’t mind making small option contract purchases with the opportunity for big upside.  A vanilla equity strategy with a very low rate of return after commissions may have huge returns on options when handled correctly.

Real Traders

Remember that you never have to feel like any “type” of trader.  Real traders simply find a way to make money, they don’t try to conform to any mold.  Always trust yourself more than anyone else, and apply discipline while removing emotion from your trading.  Finally never stop evolving, there are always new resources, changes to the market, and new technologies that impact trading.  Nothing will work forever, but there will always be opportunity.

The Relevance of the Bid-Ask Spread to Traders

The bid ask spread is the difference between the bid price and ask price of a stock.  In most high volume US stocks, the spread is normally just 1 penny, meaning the offer price is one cent higher than the bid.  This is the lowest denomination that can be published on the book of a stock, although in dark pools transactions may occur at fractions of a penny so the spreads here are effectively smaller at times.  Even though in many high volume securities the spread is one penny, it is not required or mandated to be so small.  In fact there are many instances where we may see larger spreads, and traders should be aware of why they may differ and change.

Although high volume low price stocks will normally have the smallest spreads, many popular US stocks regularly trade with spreads of larger than one penny.  These are the factors  most likely to affect the spread in a stock.

  • Price of stock
  • Volume of stock
  • Volatility of stock
  • Market maker activity

These factors are not necessarily in order of importance, although designated market makers of course have the obligation to facilitate orderly trading activities and keeping spreads reasonably tight is a big part of maintaining order.   This means that market makers effectively can keep a spread as tight as they wish (up to one penny) although large orders or extreme volatility (such as in the flash crash) may overwhelm even the market makers.

Generally speaking as a stock price rises, the spread will widen.  This is intuitive since the higher price may effectively cancel out the spread widening on a percentage basis.  IE if a $10 stock has a 1 penny spread the spread is the same on a percentage basis as a $100 stock with a 10 penny spread.  Also because the stock is more expensive per share, there is generally less shares posted on the books than a lower priced security.

Volume will affect the spread in the same way.  If there are fewer shares transacting, there is a higher likelihood that there will not be shares posted on each penny increment on the books and wider spreads are generally seen.

Higher volatility can create wider spreads.  If a stock is very volatile, its fair value at any one point in time is generally less agreed on by the market as a whole.  This means that all of the buy/sell interest will not be tightly centered around the last transaction price, and wider spreads are seen.

Spreads are very pertinent to high frequency traders, especially algorithmic traders.  This is because often times their entire profit goal is simply the spread.  A higher spread may generate higher profits per round lot traded for them, but it also may imply greater risk that they will not be able to exit their positions at their desired price.  It should be noted that with the rise of high frequency traders, spreads have generally become tighter as they seek to profit from smaller and smaller inefficiencies as well as add volume to the system.

All traders must be concerned with what a spread implies about the liquidity of a security.  If a trader purchases a position at the ask, which is $1 higher than the bid, the only way the trader could exit the position instantly is by selling to the bid, and assuming the loss.  In especially illiquid securities, a trader should never assume that they will be able to exit the position with a limit order at the bid or ask.  A high spread could imply the possibility of difficulty exiting the position at the desired price.

Hand traders who are scalpers are especially concerned with spreads since a wide spread may make scalping very difficult, especially during volatile trading times.

All traders should be aware though of factors that are influencing spreads, and if a trader spots a changing spread it may be useful to ask why the spread is changing and what it may mean for their trade.

 

Women Day Traders are on the Rise

A 17 year old actress, a stay at home Mom, and a young female graduate, what do these women have in common? If your first thought was that they are all scared of the stock market, guess again. Long dominated by the most machismo and, at least according to one recent study even sociopathic males, a wave of women have recently decided that they too are capable of making day trading a viable career.

Women’s Interest Surging

Our data indicates a recent surge of interest from women exploring the possibility of day trading, at least as a hobby. According to HowWeTrade usage data, 34% of new trader inquiries are now made by women! This is in stark contrast to historical data, which suggests that women strongly shy away from the trading world. According to Reuters, as of 2012, women at most represented a mere 5% of professional traders.womentrader2

While this is hardly social parity, it is at least a big step in the right direction, especially for a profession that has long propagated predictions of impending failure for any woman who has thoughts of joining the exclusive ranks of male traders. What we are seeing is an influx of women from varying ages and backgrounds, and we view it as a definite positive for the industry.

Past Research

Often citing what was proclaimed to be a landmark study by the University of Cambridge which correlated profits of high-frequency London traders to their finger-digit length ratio and testosterone levels (which are partly influenced by gender), some claimed to have scientific proof that women simply were not biologically cut out to be successful traders.

Women Beating Men Today

Given the pervading perceptions, many may be surprised to learn that women are not only making up a growing percentage of day traders, but that they are also doing quite well at it.

For proof look no further than Rachael Fox, a 17 year old actress/day trader that has been featured on a number of interviews on CNBC and other popular networks. Somehow between appearing in movies with Daniel Craig and acting on Desperate Housewives, she manages to run foxonstocks, a popular website dedicated to introducing people to day trading. Rachael also claims to have personally returned 30.4% through her own trading in 2012, a figure well above the average market return for the same time period.

Rachael is not alone though, and there might be a very good reason why. In 2001 Brad M. Barber of the University of California, Davis, and Terrance Odean, currently at the University of California, Berkeley, released a study entitled “Boys Will Be Boys: Gender, Overconfidence, and Common Stock Investment” that showed based on empirical data from a large discount brokerage that men on average reduced stock gains by nearly 1% more than women did by trading too often. The reason cited: men are likely to be over-confident and act outside the scope of their competence, while women are more prone to study and understand a situation before making a judicious decision, or otherwise refrain from acting outside of their abilities.

women tradersAnother recent study by Vanguard found that in the financial crisis of 2008 men were 10% more likely to exit their positions while stocks were at lows than women. Generally experts recommend buying when stock prices are depressed since selling at lows usually reduces long term returns.

Why has it taken women so long to realize that they are at least as capable as men at trading? There are no clear answers. Guesses range from an aversion from women to risky behaviors like trading in general, to societal and group norms discouraging women from entering the profession.

Whatever the reasons, women are at last getting some long overdue support. Programs like the University of Tennessee’s Finance for the Future Initiative, which focuses on trading from the female perspective, are shifting beliefs about what female traders can accomplish. Finally women seem to be deciding that they too are capable of becoming traders and at How We Trade, we think that’s a good thing.

Stock Option Pricing Basics

While stock option pricing models can become extremely complex, the underlying factors they are taking into account to put a fair value estimate on the option contracts remain the same.

Stock options are generally priced based on 6 factors.

  1. The current share price of the stock.
  2. The strike price of the options contract.
  3. The amount of time remaining until the option contract expires.
  4. Any dividends that the stock may accrue during the option time frame.
  5. The expected volatility of the underlying stock.
  6. Current interest rates.

While this may seem complicated, it is all fairly intuitive when you think about it a little more closely. The position of the current stock price relative to the strike price of the option is likely the most influential factor in the price of every option contract. If you own a call option with a strike price of $20, and the underlying stock is currently trading at $10, there is no inherent value because the strike price is higher than the current price. A logical person would just purchase shares on the open market rather than exercise the option contract. If the reverse were true and a $10 strike price existed with the underlying stock trading at $20, there is $10 of inherent value to each share.

The expected volatility of the option and time remaining until the contract expires also play important roles in the pricing. If an underlying security has higher volatility, there is a greater chance for the value of the option to be higher at expiration. Similarly, the more time that remains until the option contract expires, the more opportunity there is for the option contract to be worth more at expiration. This is a risk for the seller of the option contract, and they expect to be compensated for this risk. Generally speaking the higher the volatility and the more time remaining until the contract expires, the more the option contract will be worth (all else being equal).

Dividends have a very obvious effect on options pricing. When a stock pays a dividend, it can be expected that the price of the stock will fall on the ex dividend date proportionately to value of the dividend paid per share. Since a dividend is expected to lower a stock’s price, this has a negative effect on call options price and a positive effect on put options price (positive meaning higher contract value). Because sellers of option contracts understand this effect and are aware of ex-dividend dates, the market will price this into the option contract value if the underlying stock is affected by dividend payments during the option contract’s life.

Perhaps the most difficult concept to understand is the effect of interest rates on option prices. American stock options are unlike their European counterparts in that the owner can choose to exercise the contract at any point before the expiration date, whereas in Europe the contract can only be exercised upon expiration. This means that each trader hypothetically has an opportunity cost of not being invested elsewhere, the opportunity cost generally given to be the current risk free rate of return.

This means that if a trader purchases the underlying security rather than the options, he will have greater capital tied up in the position, and therefore a greater opportunity cost than if he purchased the less expensive options contracts. If interest rates rise, this means that call options become more expensive to account for this increased opportunity cost in owning the position. Put another way, a buyer is willing to pay more for option contracts because of the higher opportunity cost of actually owning the position. The opposite is true for put options. Since a short seller takes possession of the capital from the sale of securities, if interest rates rise the trader can now expect a higher rate of return on the short proceeds. This makes buying put options comparatively less attractive as it ties up capital that would elsewhere be earning interest.

These are the general factors that go into creating pricing models, but the actual pricing models can become extremely complex. It is important to first have a solid grasp intuitively on how different factors affect pricing before one gets caught up in the quantitative application.

Stock Option Definition

A stock option is a contract between the seller and the buyer of the option which gives the buyer the right to purchase or sell the stated amount of shares in the future at an agreed upon price.  The buyer of the option is not required to exercise his right to purchase or sell the actual shares from the seller of the contract.   If there is no advantage to exercising it the contract will normally expire worthless.

What does this look like in the real world?  All option contracts bought and sold through brokerages are for 100 share lots, and are sold at various price increments (known as strike prices) depending on the underlying symbol.  The contracts being sold expire at various time periods in the future, which are standardized and normally fall on the third Friday of the contract month.  A buyer may buy either put or call options, and the distinction is very important.  A trader can see the full list of options contracts available to trade on what is known as an options tree.

A call option gives the buyer the right to purchase shares of stock in the future at the designated price.  A buyer will purchase a call option contract when he believes the price of the stock will increase to more than the strike price plus the cost of the option.  If the price increases, the value of the contract is likely to go up with it.  If the stock at the end of the expiration date has a higher price than the option price, the owner can then purchase the stock for the option price and if he wishes immediately sell those shares in the open market at a higher value.

A put option gives the buyer of the option the right to sell a stock security at an agreed upon price in the future.  A buyer of a put option believes that the price of a stock will fall below the strike price of the option plus the cost paid.  If on the expiration date of the option the stock is trading at a lower price than the exercise price, the owner may purchase shares from the open market at the lower price and then sell them for the agreed upon option price to the seller of the contract, and will profit the difference (minus the original cost paid).

Option contracts give traders a way to increase their profits in a trade over simply buying or shorting shares on the open market.  How do options do this?

As an example let us say that a particular stock is trading at $48.  The trader believes that by the option expiration date, the stock will be trading at $52.  Currently $50 call options are being traded at .50 per share, or $50 for the contract.  If a trader buys the contract today for $50, and he is right and the stock goes to $52 at expiration, he has now made the $1.50 difference $52 market value – $50 strike price -.50 cost paid.  So the $1.50 multiplied by the 100 shares in the contract means the trader has profited $150 on his $50 investment, a return of 300%!

If the trader invested the same $50, well $48 dollars, to buy the stock on the open market, he could have bought 1 share, and his profit would have been $4, a return of 8.3%.  The same investment in an option in this example resulted in a profit of $146 more!

The caveat to this is that option contracts do not necessarily end up being worth any money.  If the price on the expiration date was $50 or less, the contract would be worthless and the trader would lose 100% of his investment in the option.

Because there is a potential to lose 100% of your investment (investment used loosely as options are used more for short term trading) brokerages typically will require the trader to be sophisticated enough to understand how the contracts work before they will give you privileges to actually trade them.  There are also varying degrees of option privileges as more sophisticated traders are also allowed to sell option contracts, which can expose the trader to enormous amounts of risk.

I should also mention that options are used by sophisticated investors as a way to hedge risk.  If they are long a position they may also purchase put options to provide protection should the price fall dramatically, as the put options will increase in value to offset the decline on the principal investment.  Call options can also similarly be used as hedges.

There are many options trading and hedging strategies, which can become very complex.  The most important factor for a trader new to options to understand is that they increase leverage, which magnifies gains and potentially losses.  It is crucial that the trader understands how the option he purchases will change in price in various scenarios, both upon expiration and before.

What is the Stock Market

The stock market is the term we use to refer to the collective marketplace where stock securities are exchanged for agreed upon prices.  The stock market as a whole is actually a collection of loosely tied together exchanges which facilitate the actual trading.  When most people in the United States think of the stock market, they think of the New York Stock Exchange with hundreds of brokers screaming to buy and sell securities rapidly throughout the day.  While this may have been how all the stock trading was facilitated in the past, today improvements in technology have vastly changed the landscape in which buyers and sellers interact.

Today most stock volume is transacted over electronic communication networks which are publicly viewable electronic exchanges, also called ECNs, as well as in dark pools, which are another form of electronic trading where the buyers and sellers are hidden until an agreed upon price is matched.  These various exchanges and dark pools are tied together through quoting systems to form the order book of a stock.  The highest bid (coming from any exchange) and the lowest offer (also coming from any exchange) make up the national best bid and offer.  It is now illegal for most transactions to occur away from the national best bid or offer (NBBO), so even though the market is fragmented amongst various exchanges, a retail trader is still guaranteed the best price possible at any given time.  There are some exceptions where institutions may trade with each other away from the NBBO but this isn’t of much concern to any day traders.

The true purpose of the stock market is to allow corporations to access private wealth in order to make investments to grow their companies.  The benefit to private wealth is that when they invest in a company that grows, they realize the appreciation in value of that company by holding securities that increase in value.  So fundamentally if a company makes more money, and has expectations to make more money in the future, the price of the companies shares should go up.  As any market participant knows the correlation between earnings and share price is less than perfect, especially in the short term.

Of course from the way the market is structured, and the ease with which buyers and sellers can interact, traders are able to take shorter term positions in hopes of profiting from near term volatility.  The value or detriment of trading volume as compared to purely investing volume in the stock market is always being debated, but of course as long as it is legal you can count on a significant amount of total orders to be for the purposes of taking trades.

Participants in the stock market range from small “mom and pop” long term investors to high frequency trading hedge funds whose trades are directed on microsecond time frames with super powerful computers and algorithms.  Today for better or worse most volume is transacted by high frequency operations.  Some of this is a necessity to navigate the fragmented markets with large orders, while other volume is very predatory on small inefficiencies in price.  There is also a substantial amount of volume transacted in dark pools, so it would behoove any prospective trader to really understand what these are, how they operate, and how they are used.

The stock market as it exists today may be unrecognizable to past generations given technological advances, but it is none the less thriving as volume continues to generally increase year over year.

 

What is a Stock Trade

A stock trade is actually a transfer of ownership in a publicly traded corporation. The trade refers to the exchange of money for ownership rights, which are denoted in shares of stock.  In common parlance, the term trade has come to mean a shortly held position taken with the intent of capitalizing on near term volatility.  Those who do this for a living are known as day traders, but many people will buy or sell stock in shortly held positions with the hopes of making a lot of money.

An example of how this is done:

A trader buys 1000 shares of stock ABC at $50.  The stock price moves up to $54 dollars after a positive earnings announcement creates buying interest. The trader sells his 1000 shares at $54 and makes $4 of gain per share on the position.  Total earnings are 1000 x $4 = $4000.  The trader made $4000 in a short time period, or an 8% gain on his investment of $50,000.  Traders will also use some tools such as margin buying power and options to create leverage, and magnify the extent of their gains.  Caution must always be taken by the trader however as losses are also magnified by leveraged positions.

Generally speaking short term trading is discouraged by the government, both for the safety of the trader’s capital as well for general healthy functioning of capital markets, since trading increases volatility.  Let’s not forget that the purpose of capital markets are for corporations to access public wealth so they may make investments in their businesses, and for the public to invest in corporations that they believe will make money for them, so that their personal wealth will grow.  This relationship is beneficial to both parties and it is why capital markets are such positive drivers of economic growth.  The value of having short term traders involved in these markets is always up for hot debate, especially with the explosion of high frequency algorithmic trading.

No matter which side of the issue you are on, you should always understand what you are doing when you place a trade.  Always understand what exactly you are trading, the maximum amount of money you can lose, and how you can be most effective in placing your orders.  This includes understanding how your broker works, how much you pay for commissions, the types of orders you are placing, and how you are determining that a particular moment is the best time to place the trade.

As always please contact us with any questions you may have!