Verticals and Volatility
The IV component of a vertical spread, although small compared with that
of an outright call or put, is still important—especially for large traders with
low margin and low commissions who can capitalize on small price
changes efficiently. Whether it’s a call spread or a put spread, a credit
spread or a debit spread, if the underlying is at the short option’s strike, the
spread will have a net negative vega. If the underlying is at the long
option’s strike, the spread will have positive vega. Because of this
characteristic, there are three possible volatility plays with vertical spreads:
speculating on IV changes when the underlying remains constant, profiting
from IV changes resulting from movement of the underlying, and special
volatility situations.
Vertical spreads offer a limited-risk way to speculate on volatility changes
when the underlying remains fairly constant. But when the intent of a
vertical spread is to benefit from vega, one must always consider the delta
—it’s the bigger risk. Chapter 13 discusses ways to manage this risk by
hedging with stock, a strategy called delta-neutral trading.
Non-delta-neutral traders may speculate on vol with vertical spreads by
assuming some delta risk. Traders whose forecast is vega bearish will sell
the option with the strike closest to where the underlying is trading—that is,
the ATM option—and buy an OTM strike. Traders would lean with their
directional bias by choosing either a call spread or a put spread. As risk
managers, the traders balance the volatility stance being taken against the
additional risk of delta. Again, in this scenario, delta can hurt much more
than help.
In the ExxonMobil bull put spread example, the trader would sell the 80-
strike put if ExxonMobil were around $80 a share. In this case, if the stock
didn’t move as time passed, theta would benefit from historical volatility
being’s low—that is, from little stock movement. At first, the benefit would
be only 0.004 per day, speeding up as expiration nears. And if implied
volatility decreased, the trader would profit 0.04 for every 1 percent decline
in IV. Small directional moves upward help a little. But in the long run,