Most people think of terms like “bear” and “bull” when they think of vertical spreads. That is because they are commonly seen as directional plays. However, vertical spreads do have other uses. They can be used for both volatility trading opportunities and time decay trading opportunities.
Although at-the-money clearly has more value than in-the-money or out-of-the-money options, the value of at-the-money options can decay over time. This time decay is where vertical spreads become important. Investors use vertical spreads to sell the at-the-money-option. Then they either buy out-of-the-money using a credit spread, or in-the-money using a debit spread later on.
So, as you can see, using a vertical spread to help you with time decay is a very good idea. The only thing is that you need to decide when to use which spread. Whether or not you use a put spread or a call spread (sell or buy), depends on the direction in which you expect the stock to move.
The first step is to decide which at-the-money strike sell and pick a stock position. After that, the decision of whether to make a call spread or a put spread is next. Using the vertical spread, you can go either way. Bulls would either create a vertical call spread or sell a vertical put spread, if they think the stock price will increase. Bears, on the other hand, would be likely to buy a vertical put spread or sell a vertical call spread. The decision to sell or buy is not always easy, but simple risk analysis can help you to choose the correct movement.
While selling an at-the-money option as part of a vertical spread lets an investor take advantage of a time delay, there is another good use for vertical spreads, volatility trading. An option’s extrinsic value is largely determined by volatility. First, you need to understand the term “Vega”, which refers to an option’s dollar sensitivity to movements (volatility). At-the-money options have a higher Vega than or in-the-money options do.
When volatility (Vega) increases, the at-the-money option’s price increases at a much higher degree than the out-of-the-money or in-the-money options for that particular month do. Of course, a reduction in Vega has the opposite effect.
If you think there will be a rise in volatility, you could use a vertical spread to buy an at-the-money option. Then, you can sell an in-the-money or out-of-the-money option. Again, you can reverse the process, if you expect the Vega to reduce.
So, obviously, vertical spread has quite a bit to do with both time delay and volatility trading opportunities. It can help you by giving you many options, while still giving you the least possible risk. So, explore all of the possible uses for vertical spreads and reap the rewards of informed decisions.
Tags: at-the-money options, out-of-the-money options, time decay, vertical spreads, volatility trading opportunities
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