Bull Spreads not for traders?

B

Babak

I was re-reading my copy of "Options as a Strateic Investment" by McMillan and I came across this:

"...bull spreads are not for traders since the spread differential changes mainly as a function of time, small movements in price by the underlying stock will not cause much of a short term change in the price of the spread."

Anyone with experience in options care to comment? I was reading the section on spreads since I wanted to move from using straight call/put positions to using spreads. But when I came to that section I paused. He doesn't really add anything further than the above. It still left me a little puzzled as I have anecdotal evidence that spreads are used all the time (especially by professional traders) and that they are favoured over straight put/call positions.

The reason why I wanted to use spreads is that I want to separate the volatility component of the trade. Let say I think IBM will go up. I can buy the call options. But this position will leave me exposed to a potential downward move in implied volatility which could erode any gains by IBM's move upward or exacerbate a downward move by IBM.

If I enter using a bull spread (lets say using calls) then I would buy the IBM 70 call and sell the IBM 80 call (of same time duration). This hedged position would protect me in case of a decrease in the IV since the decrease in my long call's value would be offset by the decrease in my short call's value. Leaving me with a stripped leverage vehicle to trade IBM.

Is that correct? am I missing something? Thanks in advance.
 
Originally posted by Babak
If I enter using a bull spread (lets say using calls) then I would buy the IBM 70 call and sell the IBM 80 call (of same time duration). This hedged position would protect me in case of a decrease in the IV since the decrease in my long call's value would be offset by the decrease in my short call's value. Leaving me with a stripped leverage vehicle to trade IBM.

Is that correct? am I missing something? Thanks in advance.
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First off, McMillan is not anyone that I (or practically anyone) am qualified to disagree with. However, your contention here, is the purpose of a program like option-vue which is talked about in a different (but very recent) thread here.....i know 'cause i just answered someones question about it.
You can see graphically with a program like option-vue what will (should) happen at any price at any time. But just looking at what you have used as an example....the lower strike will move against you MUCH faster than the value of your short higher strike will go in your favor....MUCH much faster!!!
 
rs7,

thanks for the reply. So the bull spread (as described above) is not appropriate for such a trade? then how can I structure an option trade to limit my vulnerability to IV movements? I'm confused :confused: why then are spreads so popular?
 
Hi Babak. Spreading somewhat protects you from IV movements especially if the Iv is higher than its history. (i.e. XYZ volatility USUALLY trades at 45% but due to news is now at 60%) Just be aware that different strike prices have diff vegas so I say somewhat protected. By that I mean that a 70/75 call spread protects you better than a 70/80 IF IBm is at 70, If IBM is at 80 and you buy the same call spread you are short premium so IV going higher will hurt you. Another way to play a bullish call is to buy the calendar at a higher strike if the IV differential is there-i.e. July IV at 50% and August iv much less. This way you make $ if IBM goes up OR stays around where it is.

Look up books from Natenburg and Cottle for more info.

hope this helps
 
Originally posted by GATrader
Just be aware that different strike prices have diff vegas so I say somewhat protected. By that I mean that a 70/75 call spread protects you better than a 70/80 IF IBm is at 70

Look up books from Natenburg and Cottle for more info.

hope this helps
More...

Yes, sorry, I did not clarify this. I probably wrongly assumed (since it is safe to assume all assumptions are wrong):) that you (babak, not Gat) were using today's prices. At the money or close to the money is going to move faster than out of the money, and the further out of the money, then the slower still. If in your example IBM were at 81, the spread could help you achieve your objective. But not at 67 and change, or wherever it closed today. And the 70/75 spread as GATrader says, would be more effective as well....for exactly the reasons he states.
Learn about butterfly spreads....possibly a viable strategy for you to try. Just watch out for commisions, as you will be putting on 4 positions to a spread rather than two.
 
If you're worried about vol's decreasing but want to play for a bull move, why not sell the put spread? Then you're short the option with more vega.
 
Put spreads selling could be short or long vega depending on where the underlying is. Put spreads could be a good trade on a bullish call with one caveat-the skew. Equities generally have higher put vols which flatten when stocks goes up. So when you sell the put spread you are long lower strike. Just make sure you are not buying the "a" strike at x% IV and selling the "b" strike at a much lesser vol since you can get whacked that way. You might be right with direction and make very little on spread.
 
Thanks for the info guys. My brain is much right now. I'm going to study the posts and write when I am my coherent self again. I'm sure I'll have some more questions. :p
 
thanks for the info, I said hey why not sell the put spread but I did not write that response because options are not my specialty. However, if I wanted to put on a put spread in a particular stock and not spend the money on option vue which I demoed; but I do not trade options enough to justify the expense, how would I go about checking on the vols or a get a graph. I guess I am asking what is the easiest most cost effective way for a non option professional to get a good analysis once he has a direction in mind as opposed to a volatility forecast.

thanks
 
I think that selling put spreads in high vols usually works better that buying call spreads. Using a larger differential in strikes will compensate for the skews. I like using call spreads closer to expiration when the vol difference is not as important. ( ex. .50 for 5 pt vertical.)
 
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