Vertical Spreads: What Changes Your Strategy Selection?

Key Concepts

• Vertical Spreads: Options strategies involving buying and selling options of the same type (calls or puts) with the same expiration date but different strike prices.
• Directional Trades: Trades made with the expectation that the price of an underlying asset will move in a specific direction (up or down).
• Call Debit Spread: A bullish strategy where you buy a call option and sell a call option with a higher strike price.
• Call Credit Spread: A bearish strategy where you sell a call option and buy a call option with a higher strike price.
• Put Credit Spread: A bullish strategy where you sell a put option and buy a put option with a lower strike price.
• Put Debit Spread: A bearish strategy where you buy a put option and sell a put option with a lower strike price.
• Put-Call Parity: A principle that states the price of a European put option and a European call option with the same strike price and expiration date should be equal, adjusted for the present value of the strike price and any dividends.
• Implied Volatility (IV): The market's forecast of the likely movement in a security's price.
• Intrinsic Value: The value of an option if it were exercised immediately.
• Extrinsic Value: The portion of an option's price that exceeds its intrinsic value, representing time value and implied volatility.
• Bid-Ask Spread: The difference between the highest price a buyer is willing to pay for an asset and the lowest price a seller is willing to accept.
• Liquidity: The ease with which an asset can be bought or sold in the market without significantly affecting its price.

Vertical Spreads for Directional Trading

Vertical spreads are presented as a method for placing directional trades, offering defined risk. Several types exist:

• Call Debit Spread: Bullish strategy.
• Call Credit Spread: Bearish strategy.
• Put Credit Spread: Bullish strategy.
• Put Debit Spread: Bearish strategy.

The concept of put-call parity is highlighted, indicating that certain spread combinations are synthetically the same in terms of value. For instance, an in-the-money (ITM) or out-of-the-money (OTM) short put spread is equivalent in value to an ITM call debit spread. Similarly, selling a call spread is synthetically the same as buying an ITM put spread. The discussion emphasizes a preference for trading OTM spreads.

Long Call Spreads and Short Put Spreads (Bullish Strategies)

These two strategies are identified as having identical risk profiles and are both bullish. Specifically, selling an OTM short put spread is equivalent to buying an ITM long call spread, offering the same risk-reward. The preference for one over the other is attributed to market liquidity and spread width. OTM credit spreads generally have tighter bid-ask spreads compared to ITM debit spreads because ITM options possess intrinsic value, leading to wider market prices.

Short Call Spreads and Long Put Spreads (Bearish Strategies)

These are also synthetically the same bearish strategies. The choice between them is based on trading location (OTM vs. ITM). The general approach is to trade OTM spreads across the board. Long spreads are typically initiated at-the-money (ATM) or OTM, while short spreads are always executed ATM or OTM, with a deliberate avoidance of ITM spreads.

Using Implied Volatility to Differentiate Credit and Debit Spreads

The level of implied volatility (IV) is a key factor in deciding between credit and debit spreads:

• High Volatility: Favors selling OTM premium, suggesting the use of credit spreads.
• Low Volatility: Suggests looking at ATM debit spreads, as these are used to capitalize on anticipated outsized moves.

Basic Spread Mechanics

Credit Spreads

• Construction: Sell an OTM option and buy a further OTM option.
• Profit Target: Aim to collect approximately one-third of the width of the strike prices. For a $10 wide spread, the target collection is around $3.
• Probability of Profit: The greater the distance from the underlying and the wider the "wings" (strike width), the higher the probability of profit.
• Trade-off: Going further OTM increases probability but decreases potential profit. This reflects the universal market principle of risk and reward.
• Short Strike Impact: A higher probability of profit (POP) is associated with the short strike.
• Metric: The 1/3 width collection metric aims for a 60-70% probability of success, balancing reward and risk. Moving further OTM increases probability but reduces reward.

Debit Spreads

• Construction: Buy an ITM option and sell an OTM option, where the intrinsic value of the long option exceeds the debit paid.
• Setup: These are typically set up as 50/50 probability trades.
• Benefits: This setup can provide a slight positive time decay and a breakeven point below the stock price, particularly with put spreads.
• ATM Debit Spreads: Generally result in a 50/50 probability shot.
• OTM Long Spreads: These are low-probability trades but offer significantly higher reward potential than ATM trades.
• Time Decay: Debit spreads can be slower moving and require time to develop.

Key Takeaways on Vertical Spreads

• Directional Bets with Defined Risk: Debit and credit spreads are tools for taking directional bets with defined risk.
• Similar Risk Profiles, Different Setups: While the risk profiles of different spread types can be similar (e.g., short call spreads and ITM put spreads), their construction and execution differ.
• Put-Call Parity and Market Execution: Put-call parity illustrates the theoretical equivalence of certain spreads. However, actual market execution can differ due to bid-ask spreads and liquidity. For example, if a call spread is sold for $3, the equivalent ITM put spread might be theoretically worth $7, but due to wider markets, it might trade at $6.80-$7.20. Executing the put spread at $7.30-$7.40 (mid-price) could lead to immediate fill and potential price improvement, closer to the theoretical $7.
• IV and Spread Choice:
  • Low IV: Use debit spreads, typically ATM, for more directional plays.
  • High IV: Use credit spreads.

The discussion highlights that when trading wide markets, it's often beneficial to "go to the other side" of the bid-ask spread to achieve better pricing. The example of trying to sell a spread at $7.40 or $7.50 (mid-price) and not getting filled, while the true mid-price is closer to $7, illustrates the impact of wide markets on execution.