Vertical Spreads

A Denver Trading Group

Options Interest Council
presentation
by
Ken Sheppard
 Review of Option Concepts

• Leverage

• Protection

• Getting paid for that protection

 Key Trade Offs

• Potential risk

• Probability of profit

• Potential profit
 The Battle
• Time erosion vs. favorable move in stock price
• Fewer days to expiration
– Cheaper
– Smaller loss
– Higher probability
• More days to expiration
– More time for a favorable move
– Less price erosion
– More sensitive to changes in IV
 Intrinsic Value & Time Value
Stock Price = $ 56.00
50-strike Call Option = $ 9.00
Expiration = 90 days

Time Value
Stock Price = 56 = 3.00
Option
Intrinsic Premium =
Value
9.00
= 6.00
Strike Price = 50
 Option Pricing
Stock Price = $ 56.00
50-strike Call Option (IV = 35) = $ 9.00
Expiration = 90 days

TV=9
TV=7
TV=5
TV=3
Stock Price = 56

IV=6 IV=6 IV=6 IV=6

Strike Price = 50

Imp V = 35 Imp V = 50 Imp V = 65 Imp V = 80

 Option Pricing
Stock Price = $ 56.00
50-strike Call Option (Exp = 90) = $ 9.00
Implied Volatility = 35

TV=5
TV=3
TV=2
Stock Price = 56 TV=1

IV=6 IV=6 IV=6 IV=6

Strike Price = 50

Exp=30days Exp=60days Exp=90days Exp=180days

Call pricing curve
Call pricing curve (cont.)

Time value premium

is greatest ATM

Intrinsic value is zero

until strike price is passed.
Call pricing curve (cont.)

As IV shrinks,
the price curve merges with
the intrinsic line.

As expiration draws closer,

the price curve merges with
the intrinsic line.
 Time Decay

Exp=120days Exp=90days Exp=60days Exp=30days

 Long Call

+5

0
45 50 55 60

-5
 Profitability
• Foremost:
– Favorable movement by the underlying

• Secondarily:
– An increase in implied volatility
 Which option to buy?
“The shorter term your horizon, the higher the
delta should be!”
• Day-traders
– Use the underlying (2 min to 2 days)
• Short-term swing traders
– ITM, short-term (2 days to 2 weeks)
• Intermediate-term position traders
– ATM (2 weeks to 2 months)
• Long-term (2 months to 2 years)
– OTM, LEAPS
 The frustration problem
• Bid-ask spread
• Implied volatility changes
• Risk management
 What is a spread?
• A strategy which involves taking
simultaneous but opposing positions in
different instruments
– Being long in the instrument which appears to
be under priced
– Being short in the instrument which appears
to over priced

• The trader hopes to profit when the prices

return to their expected relationship
 Why spread?

• Reduces the effect of short-term ‘bad luck’

• Reduces short-term risk

- Natenberg p133
 Vertical spreads
• Directionality is the primary concern
– Initially bullish or bearish
– Remain bullish or bearish regardless of
changes in market conditions
• Volatility is a secondary concern
• At expiration
– A minimum value of zero (both options OTM)
– A maximum value of the spread (both ITM)
 Bull Call Spread
20
Sell a call (put) at a
higher exercise price

Whenever the trader buys the lower

exercise price and sells the higher
exercise price, the position is bullish!

Buy a call (put) at a

lower exercise price
-20
 Bull Call Spread
XYZ price at Oct 30 Oct 35 Total
expiration profit profit profit

25 -$300 +$100 -$200

30 -300 +100 -200

32 -100 +100 0

35 +200 +100 +300

40 +700 -400 +300

45 +1,200 -900 +300

 Call vs. spread purchase
400
XYZ common, 32
300
XYZ Oct 30 call, 3
XYZ Oct 35 call, 1
200
Call does better
100 if price > 36
Spread does better
if price < 36
0
Limited risk
-100
BE = 32
-200

-300

-400
25 30 35 40
 Least aggressive (ITM)
20

Stock

-20

•Larger probability
•Smaller potential
 Aggressive (ATM)
20

Stock

-20

•Substantial returns if
stock price rises
Extremely aggressive (OTM)
20

Stock
0

-20

•Inexpensive
•Remote chance
 Position analysis
• Theoretical edge
position will cross current price above zero line
• Delta
the slope as it crosses is determined by magnitude
• Gamma
‘ + ’ is convex (smiles); ‘ - ’ is concave (frowns)
• Theta
‘ + ’ will shift upward over time; ‘ - ’ will shift downward
• Vega
‘ + ’ will shift upward with increasing volatility;
‘ - ’ will shift downward with increasing volatility
 How volatility affects bull spreads

• Stock price: 25
• Time to expiration: 3 months
• Position:
– bco at 25
– sco at 30

• What happens to the price of the spread is

implied volatility increases?
How volatility affects bull spreads
Stock price = 25
Implied volatility 25/30 Bull call sp Position vega
(theoretical value)
20% 1.02 3.69
30% 1.31 2.20
40% 1.49 1.25
50% 1.59 0.71
60% 1.64 0.38
70% 1.67 0.17
80% 1.68 0.03
Interest rate = 2.0%, American style expiration
 How volatility affects bull spreads

• If implied volatility is too low

– Focus on purchasing the ATM option
(the option whose delta is closest to 50)
• If implied volatility is too high
– Focus on selling the ATM option
(the option whose delta is closest to 50)
 Vertical spread summary

Low Volatility High Volatility

Debit Credit
Bull Bull Call Spread Bull Put Spread
Sell higher call Sell higher put
Buy lower call Buy lower put
Bear Bear Put Spread Bear Call Spread
Buy higher put Buy higher call
Sell lower put Sell lower call

© Gryffindor Global Investments LLC Ken.Sheppard@comcast.net

 Which spread is best?
1. Determine the time horizon
2. Decide how bullish or bearish you are
– The delta of the spread
– The size in which the spread is executed
3. Focus on the ATM option
– Assess implied volatility
– If IV is low, buy the ATM option
– If IV is high, sell the ATM option
4. Compare cost to expected return
© Gryffindor Global Investments LLC Ken.Sheppard@comcast.net
 Rules of thumb
• Do not rank by max profit potential
– This will always be the OTM spreads
• Estimate where stock price may advance
by expiration
– Using a trading system
– Using a Monte Carlo simulator, or
– Using 2x the time value of the ATM call as an
estimate of stock’s advance
• Compare cost to expected return
© Gryffindor Global Investments LLC Ken.Sheppard@comcast.net
 Follow up adjustments
• Stock falls below long strike
– Close spread as a spread transaction 30 DTE
• Stock remains below breakeven
– Close spread as a spread transaction, or
– Sell long call and let short call expire worthless, or
– If underlying drops, buy back the short call (< 0.10) & hold the
long call, hoping for a rise in price
• Stock rises above breakeven, but below short strike
– Close spread as a spread transaction with a small profit
• Stock rises above short strike
– If assigned, exercise the long call to deliver shares for maximum
profit

© Gryffindor Global Investments LLC Ken.Sheppard@comcast.net

 Stops
• Stock stops
• Exit at 40% or 50% loss
• If spread doubles, sell half for a free trade
• Then, implement tight trailing stop
• Finally, sell remainder at 80% of spread
• Exit debit spreads before 30 DTE

© Gryffindor Global Investments LLC Ken.Sheppard@comcast.net

 Option Concepts
• Leverage
• Protection
• Pay for protection