Vertical Spreads - Time Decay and Volatility Trading Opportunities
When vertical spreads are mentioned, they quite often come with
monickers such as “bull” and “bear”. This lends most to think of
vertical spreads as directional plays which is true. However,
vertical spreads can be used to take advantage of two other
potential trading opportunities – time decay and volatility
movement.
If you are looking for a fully hedged way to take advantage of
time decay, a vertical spread can be an excellent tool. Knowing
a little about them now, you will recall that a vertical spread
has a limited profit potential but also a limited loss scenario
for both the buyer and the seller. So, how do we use this
covered trade to take advantage of time decay.
At-the-money options have more extrinsic value than their
similar month in-the-money or out-of-the-money options. Since it
is an option’s extrinsic value that decays away over time, you
could set up a vertical spread by selling an at-the-money option
and buying either the out-of-the-money option (creating a credit
spread) or buying an in-the-money option (creating a debit
spread). If the stock holds tight to the out-of-the-money
option, the option’s extrinsic value will decay away at a faster
rate than either the in-the-money option or the out-of-the-money
option due to the fact that the at-the-money option has more
total extrinsic value to decay in the same amount of time as the
others.
Creating the vertical spread by selling an at-the-money option
and buying an out-of-the-money or in-the-money option as a hedge
looks like a good idea, but now there are a couple choices.
Should you do the put spread or the call spread? Should you buy
it or sell it? The decision of what to do from here should first
be based on which way you think the stock will move. Although
you are playing for time decay and you are assuming an overall
lack of movement, you can’t expect the stock not to move at all.
So even though you are playing time decay, you still want to
form an opinion about in which direction the stock is most
likely to move. By doing this, you’ve now give yourself another
way of making the trade profitable. You are playing for a lack
of movement but now you can still win if you pick the right
direction. This scenario presents you with two ways to win and
only one to lose.
Now that you have picked which at-the-money strike you are going
to sell and you’ve picked your anticipated stock position you
still have a decision to make. Do you do the call vertical
spread or the put vertical spread? Remember both the vertical
call spread and a vertical put spread allow you to participate
in either stock direction. For the bulls, you can buy a vertical
call spread or sell a vertical if you think that the stock will
go up. For the bears, you can buy a vertical put spread or sell
a vertical call spread. For each direction there are two choices
to decide from. One is a purchase, one is a sale. The best way
to decide which to do, other than your own style or comfort
ability is a simple risk/reward analysis.
By selecting an at-the-money option to sell as part of a
vertical spread, an investor can execute a time decay play with
a hedged position.
Much in the same way that a vertical spread can be used as a
time decay play, it can be used as a volatility play. We stated
earlier that an at-the-money option has more extrinsic value
than any other option in its expiration month. This is due to a
number of contributing factors including time but it is in no
small way due to volatility. Volatility is a huge component of
an option’s extrinsic value. An option’s dollar sensitivity to
movements in implied volatility is known as vega. Obviously, an
at-the-money option will have a higher vega (volatility
sensitivity) then will an in-the-money or out-of-the-money
option in the same month.
As volatility increases, the at-the-money option will increase
in price to a greater degree than will an in-the-money or
out-of-the-money option in the same month. As volatility
increases, the at-the-money option will increase in price to a
greater degree then will an in-the-money or out-of-the-money
option whose vega’s will be less. Conversely, the at-the-money
option will lose value at a greater rate than an in-the-money or
out-of-the-money option should implied volatility decrease. The
question now is how to use the vertical spread to take advantage
of anticipated movements in implied volatility. Remember, the
vertical spread affords you the luxury of being hedged on either
side of the trade – both as a buyer and a seller of the spread.
So, if you think that implied volatility is likely to increase,
you can set up a vertical spread by buying an at-the-money
option and selling either the in-the-money or out-of-the-money
option against it. Conversely, if you feel implied volatility
will decrease; you can set up a vertical spread by selling an
at-the-money option and buy either an out-of-the-money or an
in-the-money option against it.
As to how to set it up, you would follow the same guidelines as
you would for setting up a vertical spread to take advantage of
time decay. Decide which direction you feel the stock would most
likely move. If you feel the stock would most likely rise, you
will have to decide between buying a vertical call spread and
selling a vertical put spread.
Either way, the spread will have to be constructed with the
at-the-money option being long if you feel volatility will
increase or short if you feel volatility will decrease. If you
feel the stock would most likely fall, you will have to decide
between buying a vertical put spread and selling a vertical call
spread. Again, either way, the spread will have to be
constructed with the short option being the at-the-money.
As you can see, the vertical spread does not have to be used
only in directional scenarios. It is very versatile allowing the
investor several choices among a diverse group of potential
uses. It also affords limited risk, albeit limited profit
potential, to both the buyer and the seller. _/_/_/_/_/_/_/_/_/_/_/_/_/_/_/_/_/_/_/_/_/_/_/_/
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and Explosive Profits. Discover how to protect your
investments with the leveraged power of options. Step
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