Vertical Option Spread Trading Pros and Cons

 

Trading naked options outright might make more sense

On the surface, vertical spreads appear to offer traders the best of all worlds.  They are limited risk, directional positions, with a built in hedge.  Yet, there are two relatively unobvious draw-backs that sometimes make vertical spread trading a frustrating venture; delta and time.

If you aren’t familiar with delta, it is simply the pace at which the value of a particular option fluctuates relative to the underlying futures contract.  For instance, if an option has a delta of .30 it will gain or lose 30% of a corresponding move in the futures market.  To illustrate, an option with a delta of .40 and the S&P goes up 10.00 points, a call option should have increased in value by about 4.00.  Of course, market pricing is based on emotion just as much as it is mathematics, so the relationship between option value and futures value isn’t always according to theory.   In fact, there are times in which software identifies an option as having a low delta but market participants wildly bid prices up to unbelievably high prices that far exceed expectations based on the estimated option delta.  Nonetheless, it is important to realize as a vertical spread trader at any point before expiration, volatility and time value can interfere with profitability of the trade.  It is sometimes necessary to hold the position until expiration to achieve a worthwhile profit.  This is particularly true during times of high volatility which has a tendency to neutralize the delta of the trade.

Beginner traders often learn the hard way that in highly volatile market conditions it is possible for a trader long a vertical call spread to fail to make gains, or even sustain a loss, despite the market moving in the desired direction.  Using the previous example, this can happen if the value of the short 2125 call rises nearly as much as the value of the long 2075; some refer to this as a vertical spread handcuff.  Such an occurrence is more common than most would think.  This is because speculators often bid up the price of the “cheaper” options with distant strike prices due to affordability.  The increased demand for these more affordable strikes often lead to higher percentage gains than options with strike prices closer to the market.    Plainly, unless you are planning on holding the trade for a substantial amount of time, vertical spreads might not be the optimal strategy because you can be “trapped” into an unprofitable trade even if your original speculation was accurate.

Similarly, if time value erosion outpaces the benefits of the underlying market moving in the desired direction, a long vertical trader can find himself in a position in which he is losing money despite being “right” in price prediction.

The implications of vertical spreads for option sellers (as opposed to buyers) is even worse, the purchase of the “insurance” option typically encourages traders to execute trades in higher quantities due to lower margin requirements for vertical spreads relative to naked option selling.  Many don’t notice it until it is too late, but they are often taking on more risk than would be the case selling naked options in lower quantities. Further, premium collectors typically sell options with strike prices closer to the market in order to make up for the premium paid for the protective option. Thus, the strategy of selling vertical spreads can sometimes become more dangerous that selling naked options!

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