Directional spreads

[candeo]

I never understood why people would even consider simple 2 legs vertical spreads. What are you trying to achieve? Reduce your cost? Just buy less, or have tighter stops, at least you will keep all of your upside potential. Trying to capture some premium? Then why enter a directional trade where you are going to give up a lot of premium on the other leg? There are many other strategies for this.
These kind of spreads (and others, as well as covered calls) are just a way for your brokers to make twice as much commissions and for you to believe that you are doing something smart. It won't improve your risk/reward. I would be happy if someone could give an example of a directional spread that would yield better results than a simple long call/put with good money management and position sizing.

 

[asap]

a put or call vertical has 2 main advantages over an outright option contract. the most important is it doesn't carry vega risks. in addition, if the spread is either atm or otm, it also offers a positive theta.

these two made this kind of spreads one of the most used option vehicles for directional strategies in the professional arena. btw, a bullish put/call vertical is the synthetic equivalent of a long collar (long stock, short call and long put), which is the most positive expectancy directional trade, as it captures the hypothetical underlying positive drift, while limiting the downside potential to certain threshold.

the only outright option contract that might get closer to a vertical spread in terms of long term expectancy is the long itm call, because it doesn't carry much theta or vega risks, while featuring an uncapped profit potential. however, it requires in most cases, a substantial capital outlay when compared with its expected payout.

the outright atm's and especially the otm's are purely speculative plays. they carry substantial negative expectancy, as the iv skew is modeled to eliminate abnormal returns in those strikes while theta becomes a huge burden against the holder.

regarding the problem of added comms in the spread vs the outrights, it is not always true. for instance, the seller of a put vertical, while pays comms and endures slippage once, benefits from the probable expiration of the spread worthless, and thus it effectively has the same costs than an outright trader that will always have need to enter and exit a profitable trade or exercise its call/put and close the underlying instrument position afterwards.

 

[nikko309]

Quote from candeo:

I never understood why people would even consider simple 2 legs vertical spreads. What are you trying to achieve? Reduce your cost? Just buy less, or have tighter stops, at least you will keep all of your upside potential. Trying to capture some premium?

Stops are no guarantee that you maintain a profit/minimize a loss.

If a credit spread expires, there are no a more commissions than buying you put (or call) and having to close it.

Selling a leg offsets the TP paid for the long leg, particularly with inflated IV situations. IV collapse is somewhat mitigated.

Simply put, just because you don't see the potential of this strategy, it doesn't mean that others can't employ it profitably. LOL.

 

[daddy'sboy]

Quote from asap:

a put or call vertical has 2 main advantages over an outright option contract. the most important is it doesn't carry vega risks. in addition, if the spread is either atm or otm, it also offers a positive theta.

these two made this kind of spreads one of the most used option vehicles for directional strategies in the professional arena. btw, a bullish put/call vertical is the synthetic equivalent of a long collar (long stock, short call and long put), which is the most positive expectancy directional trade, as it captures the hypothetical underlying positive drift, while limiting the downside potential to certain threshold.

the only outright option contract that might get closer to a vertical spread in terms of long term expectancy is the long itm call, because it doesn't carry much theta or vega risks, while featuring an uncapped profit potential. however, it requires in most cases, a substantial capital outlay when compared with its expected payout.

the outright atm's and especially the otm's are purely speculative plays. they carry substantial negative expectancy, as the iv skew is modeled to eliminate abnormal returns in those strikes while theta becomes a huge burden against the holder.

regarding the problem of added comms in the spread vs the outrights, it is not always true. for instance, the seller of a put vertical, while pays comms and endures slippage once, benefits from the probable expiration of the spread worthless, and thus it effectively has the same costs than an outright trader that will always have need to enter and exit a profitable trade or exercise its call/put and close the underlying instrument position afterwards.

Nice summary!
db

 

[panzerman]

the only outright option contract that might get closer to a vertical spread in terms of long term expectancy is the long itm call, because it doesn't carry much theta or vega risks, while featuring an uncapped profit potential. however, it requires in most cases, a substantial capital outlay when compared with its expected payout.

Well, payout = probability*(reward/risk).

Let's examine two positions, buying an OTM call for 0.25 , and buying a ATM call for 1.00. You will close either position if you have a 0.25 gain in the position. The OTM strike will be 1.282 std. devs from the current price. At 1.282 stddev, the area under the bell curve to the left of that price is 90% of the total area. Also at 0.0 stddev, the area to the left of that price is 50% of the total area.

Therefore:
OTM payout = 0.10*(0.25/0.25) = 0.10
ATM payout = 0.50*(0.25/1.00) = 0.125

The ATM position would have a higher payout. Obviously, this is a hypothetical position, but the empirical evidence is that over time ATM and ITM strikes have the highest payouts.

 

[candeo]

Great post asap, thank you for the comments.
I guess, as I am a trend follower, the elimination of Vega risk is not important for me as I like to play DITM options and hold them for sometimes up to 2-3 months. As my strategy is based on having some very large winners once in a while, restricting the profits with vertical spreads does not seem attractive. I agree though that my strategy does require more cash to play the DITM instead of ATM or OTM. Maybe I should consider verticals, rolling them to higher strikes as position becomes profitable?

 

[MTE]

Quote from candeo:

Great post asap, thank you for the comments.
I guess, as I am a trend follower, the elimination of Vega risk is not important for me as I like to play DITM options and hold them for sometimes up to 2-3 months. As my strategy is based on having some very large winners once in a while, restricting the profits with vertical spreads does not seem attractive. I agree though that my strategy does require more cash to play the DITM instead of ATM or OTM. Maybe I should consider verticals, rolling them to higher strikes as position becomes profitable?

Huh!? You contradict yourself in the same paragraph!

Rolling a vertical is essentially closing the existing trade and opening a new trade. Seems like an unnecessary expense, especially when you depend on a big winner, on which you may miss out with a vertical - i.e. you won't be quick enough to roll up and will miss the move.

 

[asap]

there are some problems with the spread approach when applied to your strategy. first, you are not sure of when the price move will happen. with spreads, either you chose hi leverage bets in front month or low leverage bets in back month. since you'd like to have both (that is, hi leverage and wider time frame), then the spread strategy might be suboptimal. doing hi leverage front month spreads and rolling them is dangerous, because, you might end up with a full loss even with neutral price action or slight positive drift, while with the itm outright, you'd always, at least, break even. if you chose a back month spread instead, you wont get as much bang for the buck and, in addition, if the price moves aggressively in your favor you have a nasty cap to your profit potential and hi rolling costs.

all this is based on the assumption of expecting "home runs" (ie merger announcements), which statistically, could be described as bell curve outliers. in my opinion, the best way to capture these outliers in a risk conscious manner is through itm outright because you have some downside protection, while maintaining the full payoff potential.

conversely, if what you refer as "home runs" are just normal statistical results and thereby already priced in contracts, then you could most probably optimize your strategy using spreads. the sweet spot for these spreads would be front months with approx risk:reward ratio of 1 to 2. i can explain why in a later post. now i head to bed, as i am across the atlantic.

 

[atticus]

Quote from candeo:

I would be happy if someone could give an example of a directional spread that would yield better results than a simple long call/put with good money management and position sizing.

I was long >100 NDX 1800/1900/2000 flies at $32 [average] basis the natural fly debit. Sold in ~10 days at $49. The fly was $.80 wide.

Selling equivalent deltas in buying the ATM put would've earned $9 over the same duration.

$9 < $17

 

[mushinseeker]

Any vol surface screwed up by fda plays, earnings, news pending would give you a much better payoff than a simple long call scenario--provided you know how to take advantage of it and most improtant-manage it.