Vertical Spreads
- Thread starter jb514
- Start date
the put vs call verticals would be very close , close enough to be untradable in terms of locking in meaningful profit once commissions and bid/ask spread and execution risk are factored in. The differrence could be attributed to interest rate, dividends and short stock rebate since that messes up put call parity.
If the bid/asks were narrow enough you could sell a box for something close to $5.80 and wait until it expires worth $5 even, a 16% profit on a risk free trade The market is never so generous so I assume the bid/ask spreads are wide and the disparities you see between the vertical call spread and the vertical put spread are due to the randomness of where you can buy or sell within those wide B/A spreads.
When volatility is very low debit spreads (spreads you buy) are preferred. When volatility is very high then go with credit spreads (spreads you sell). With volatility in the middle ratio spreads, condors, and butterflies with lower Vega are preferred.
Why is this? When I say volatility is "low" or "high", I am talking about the implied volatility as compared to the historic volatility. When volatility is very low it generally means the option is priced fairly cheaply and a rise in volatility (being more likely at extreme low levels) will add to your options intrinsic value, boosting profit. When volatility is high the options are generally overpriced and a fall in volatility will cause the options to lose intrinsic value which makes them cheaper for you to buy back to liquidate the position later. When volatility is floating around in the middle I prefer to be Vega neutral or at least low Vega since an unexpected change in volatility can quickly wipe out any profit you would have made on what could have otherwise been a profitable trade.
Why is this? When I say volatility is "low" or "high", I am talking about the implied volatility as compared to the historic volatility. When volatility is very low it generally means the option is priced fairly cheaply and a rise in volatility (being more likely at extreme low levels) will add to your options intrinsic value, boosting profit. When volatility is high the options are generally overpriced and a fall in volatility will cause the options to lose intrinsic value which makes them cheaper for you to buy back to liquidate the position later. When volatility is floating around in the middle I prefer to be Vega neutral or at least low Vega since an unexpected change in volatility can quickly wipe out any profit you would have made on what could have otherwise been a profitable trade.
1) Volatility levels can be "low" or "high" compared to an arbitrary historical average.
2) Whatever the current level, that is the "fair" value. It can still go higher or lower than you expect.
3) The current option premiums are also "fair". They can still go higher or lower than you expect.
4) If you believe something is "underpriced" or "overpriced", you're beginning to impose your own bias/judgement.
5) An option premium of "10" can be underpriced to one trader, fairly priced to another and overpriced to yet another based on each of their own valuation models.
When IV is high, you overpay on the long side and get overpaid on the short side (and vice versa when IV is low). The time premium expansion is greater for the nearer money leg than for the outer leg so there is an advantage to buying spreads in a low IV environment tho not as large as you'd think due to this offset.
But remember, verticals are directional so if you get that wrong but get IV right, it will be a Pyrrhic victory as you gain 10-20+ cts from the IV expansion (the offset affects both sides) but lose the entire premium if long and wrong.
Yep, there are many gradations of P&L when you have multiple variables (price and IV change as well as time decay).
My response was geared to the OP's statement of buying verticals when IV is low. If IV expands big time, sure, there's some gravy to be had. But most of the time, it doesn't and by luck, getting 10-15 BP's of IV expansion will only slightly deaden the pain of getting the direction totally wrong.
Ignoring EA's, pending releases, etc. where IV change is imminent, how many people do you know who can predict volatility? I know none so my short answer is, with verticals, deal with direction first and foremost.
Definitely direction is first, time frame is second and volatility is third but can't be ignored either. While you are correct that volatility is not really predictable, you can still play the probabilities here by comparing IV to historical volatility(HV). If it is significantly higher than average then I look for plays where I sell premium that matches my direction and time line. If IV is very low compared to HV then I look to buy premium while making my direction and time line. When IV is around the middle somewhere I try to stay near Vega neutral since I don't know where it might go.