Verticals and Volatility

The IV component of a vertical spread, although small compared with that of an outright call or put, is still important—especially for large traders with low margin and low commissions who can capitalize on small price changes efficiently. Whether it’s a call spread or a put spread, a credit spread or a debit spread, if the underlying is at the short option’s strike, the spread will have a net negative vega.

If the underlying is at the long option’s strike, the spread will have positive vega. Because of this characteristic, there are three possible volatility plays with vertical spreads: speculating on IV changes when the underlying remains constant, profiting from IV changes resulting from movement of the underlying, and special volatility situations.Vertical spreads offer a limited-risk way to speculate on volatility changes when the underlying remains fairly constant.

But when the intent of a vertical spread is to benefit from vega, one must always consider the delta—it’s the bigger risk. Chapter 13 discusses ways to manage this risk by hedging with stock, a strategy called delta-neutral trading.Non-delta-neutral traders may speculate on vol with vertical spreads by assuming some delta risk. Traders whose forecast is vega bearish will sell the option with the strike closest to where the underlying is trading—that is,the ATM option—and buy an OTM strike.

Traders would lean with their directional bias by choosing either a call spread or a put spread. As risk managers, the traders balance the volatility stance being taken against the additional risk of delta. Again, in this scenario, delta can hurt much more than help.In the ExxonMobil bull put spread example, the trader would sell the 80-strike put if ExxonMobil were around $80 a share. In this case, if the stock didn’t move as time passed, theta would benefit from historical volatility being’s low—that is, from little stock movement.

At first, the benefit would be only 0.004 per day, speeding up as expiration nears. And if implied volatility decreased, the trader would profit 0.04 for every 1 percent decline in IV. Small directional moves upward help a little. But in the long run, those profits are leveled off by the fact that theta gets smaller as the stock moves higher above $80—more profit on direction, less on time.For the delta player, bull call spreads and bull put spreads have a potential added benefit that stems from the fact that IV tends to decrease as stocks rise and increase when stocks fall.

This offers additional opportunity to the bull spread player. With the bull call spread or the bull put spread,the trader gains on positive delta with a rally. Once the underlying comes close to the short option’s strike, vega is negative. If IV declines, as might be anticipated, there is a further benefit of vega profits on top of delta profits. If the underlying declines, the trader loses on delta. But the pain can potentially be slightly lessened by vega profits.

Vega will get positive as the underlying approaches the long strike, which will benefit from the firming of IV that often occurs when the stock drops. But this dual benefit is paid for in the volatility skew. In most stocks or indexes, the lower strikes—the ones being bought in a bull spread—have higher IVs than the higher strikes, which are being sold.Then there are special market situations in which vertical spreads that benefit from volatility changes can be traded.

Traders can trade vertical spreads to strategically position themselves for an expected volatility change.One example of such a situation is when a stock is rumored to be a takeover target. A natural instinct is to consider buying calls as an inexpensive speculation on a jump in price if the takeover is announced. Unfortunately,the IV of the call is often already bid up by others with the same idea who were quicker on the draw.

Buying a call spread consisting of a long ITM call and a short OTM call can eliminate immediate vega risk and still provide wanted directional exposure.Certainly, with this type of trade, the trader risks being wrong in terms of direction, time, and volatility. If and when a takeover bid is announced,it will likely be for a specific price.

In this event, the stock price is unlikely to rise above the announced takeover price until either the deal is consummated or a second suitor steps in and offers a higher price to buy the company. If the takeover is a “cash deal,” meaning the acquiring company is tendering cash to buy the shares, the stock will usually sit in a very tight
range below the takeover price for a long time. In this event, implied volatility will often drop to very low levels. Being short an ATM call when the stock rallies will let the trader profit from collapsing IV through negative vega.