One of the new buzz words in the option industry is the vertical spread. Although they’ve been around for as long as option trading, popularity of the strategy has been on the rise due to historically challenging market volatility and a more sophisticated trading community.
Option buyers look to vertical spreads as a means of lowering their cost and risk of a particular trade. Similarly, option sellers seeking to collect premium as an income strategy might choose to implement vertical spreads to limit risk and lower margin. Nonetheless, we believe that in many cases trading vertical spreads might come with more baggage than benefits. Like any other strategy, there is a time and place for vertical spreads, but in my opinion, they should not be the staple of a trading portfolio.
Vertical Option Spread Overview
By definition, a vertical spread is an option strategy in which a trader makes the simultaneous purchase and sale of two options of the same type and expiration dates, but different strike prices. A buyer of the spread would be purchasing the more expensive leg of the spread, which is the option with the strike price closest to the market, and then selling an option with a distant strike price. The seller of the spread would be selling the option with the most value (the one with a strike price in closest proximity to the current futures price), and then purchasing the cheaper option.
The term vertical describes the relationship between the option strike prices while inferring the components to the spread share the same underlying contract. A horizontal option spread, on the other hand, would consist of options in the same market and strike prices, but different expiration dates.
Know the volatility tendency
Most markets have a particular direction in which they are capable of the most explosive moves. For instance, the stock market tends to take the stairs up and the elevator down. As a result, put options tend to be relatively expensive when compared to calls in the e-mini S&P 500. Even more so, S&P puts are prone to massive panic pricing in a volatile down-turn. However, S&P calls generally don’t have an explosive pricing nature. Crude oil and the grains, are typically the opposite; they have the potential to move higher faster than they can move lower. Knowing this, extra caution should be warranted when selling puts in a quiet S&P environment, or calls in a quite grain market.
Conclusion
Option Selling is not for everybody due to the prospects of theoretically unlimited risk. Yet, it is a strategy that everyone should consider in light of the high probability of success on any particular trade.
[box type=”alert” style=”rounded” border=”full”]*There is substantial risk of loss in trading futures and options.
There is unlimited risk in option selling![/box]
by Carley Garner
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