Let’s start with something simple that most option traders know. Long options, such as long calls, have limited risk. The purchase price is the risk on the position. One of the many reasons traders love options so much is that they are usually far cheaper than buying 100 or fewer shares of stock. But sometimes even options can be quite expensive, so a trader may consider a spread, such as a bull call or bear put spread. Besides a potentially cheaper trade with less overall risk, there can be other benefits as well.
Bull Call Spread
For option traders, a bull call spread (debit call spread) may help control risk even better than a long call. What if the options are very expensive or the trader is worried the stock might fall, especially in the volatile environment we are currently experiencing? One or both scenarios may cross an option trader’s mind. If that is the case, implementing a bull call debit spread might just make sense. Although the spread is still a debit, an option is bought and sold, which can possibly lower the cost and risk of the trade. But what else could benefit an option trader by doing a spread versus just buying a call or put? Do you already know? Let’s do a quick review.
Negating Volatility Risk
There is more than one answer, but today we will be talking about offsetting your volatility risk. Vega changes the option premium for every 1% change in implied volatility. If implied volatility (IV) rises, so does option premium. Generally, IV rises when stocks move lower and vice versa. For long puts, this could be good because if the stock falls and the IV level increases, premium may increase from the negative delta and increase in IV.
The same could not be said for an expected move higher especially if IV is elevated, as it has been recently. Long calls can still profit from a move higher, but IV may drop and that could offset some positive delta gains. If a spread trade like a bull call is implemented, vega could be neutralized.
Take a look at the option chain below. The long 195 call has an IV of 34.56% and a positive vega of 0.11, and the short 200 call has an IV of 33.02% and a negative vega of 0.11. The positive and negative vegas virtually offset each other, so changes in IV either higher or lower will not affect the premium if the IV basically changes the same for each strike.
As with everything in option trading, there are risk/reward trade-offs. Just knowing what they are can greatly benefit you as an option trader. At times spreads can be beneficial, as in the example above when a decrease in IV is expected with a move higher and a positive vega position is not wanted. And, of course, sometimes negating one or more of the option greeks can be detrimental.
IV is at about 22%. If it were to move up 1 percentage point to about 23%, the option would increase in value by 0.11 because of vega (see chart below). The new value would be about 2.98 (2.87 + 0.11). That would be beneficial for the position. But what if IV levels dropped to historical levels if the underlying rallied? If IV decreased by 6% (22% – 16%) to about 16%, the new option value would be about 2.21 (2.87 – (6 X 0.11)).