those profits are leveled off by the fact that theta gets smaller as the stock
moves higher above $80—more profit on direction, less on time.
For the delta player, bull call spreads and bull put spreads have a potential
added benefit that stems from the fact that IV tends to decrease as stocks
rise and increase when stocks fall. This offers additional opportunity to the
bull spread player. With the bull call spread or the bull put spread, the trader
gains on positive delta with a rally. Once the underlying comes close to the
short option’s strike, vega is negative. If IV declines, as might be
anticipated, there is a further benefit of vega profits on top of delta profits.
If the underlying declines, the trader loses on delta. But the pain can
potentially be slightly lessened by vega profits. Vega will get positive as the
underlying approaches the long strike, which will benefit from the firming
of IV that often occurs when the stock drops. But this dual benefit is paid
for in the volatility skew. In most stocks or indexes, the lower strikes—the
ones being bought in a bull spread—have higher IVs than the higher strikes,
which are being sold.
Then there are special market situations in which vertical spreads that
benefit from volatility changes can be traded. Traders can trade vertical
spreads to strategically position themselves for an expected volatility
change. One example of such a situation is when a stock is rumored to be a
takeover target. A natural instinct is to consider buying calls as an
inexpensive speculation on a jump in price if the takeover is announced.
Unfortunately, the IV of the call is often already bid up by others with the
same idea who were quicker on the draw. Buying a call spread consisting of
a long ITM call and a short OTM call can eliminate immediate vega risk
and still provide wanted directional exposure.
Certainly, with this type of trade, the trader risks being wrong in terms of
direction, time, and volatility. If and when a takeover bid is announced, it
will likely be for a specific price. In this event, the stock price is unlikely to
rise above the announced takeover price until either the deal is
consummated or a second suitor steps in and offers a higher price to buy the
company. If the takeover is a “cash deal,” meaning the acquiring company
is tendering cash to buy the shares, the stock will usually sit in a very tight
range below the takeover price for a long time. In this event, implied
volatility will often drop to very low levels. Being short an ATM call when