Using Spreads to Offset Volatility Risk

Posted on Thursday, January 17, 2019 at 3:44 PM

When options traders purchase call options, they knows they will have limited risk (the most that can be lost is the amount paid for the option) and at the same time unlimited profit potential. One of the reasons traders love options so much is that they are usually far cheaper to buy than shares of stock. But sometimes even options can be quite expensive, so a trader may consider a spread such as a bull call spread or bear put spread. In addition to a potentially cheaper trade and lower overall risk, there could be another benefit. 

A bull call spread (debit call spread) may be able to help control risk even better than a long call. What if the options are very expensive or the trader is worried that the stock might fall? One or both of these scenarios may cross a trader’s mind, especially in the volatile environment we have seen. If that is the case, then implementing a bull call debit spread might just make sense for the options trader. 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?

The answer is 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. Not only can you make money from the stock falling, an option trader might be able to make money if IV increases because the put premium will increase too.

The same could not be said for an expected move higher especially if IV is elevated like the most recent market conditions. Long calls can still profit from a move higher, but IV may drop and that could offset some delta gains. If a spread trade like a bull call is implemented, vega could be “neutral” as seen below.

The long 325 call has a positive vega of 0.1405, but the short 330 call has a negative vega of 0.1405. The positive and negative vegas offset so that changes in IV will not affect the premium if the IV basically changes the same for each strike.

Just like everything in option trading, there are risk/reward trade-offs. Just knowing what they are can greatly benefit you as an option trader.

John Kmiecik
Senior Options Instructor
Market Taker Mentoring, Inc.

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