Forums > Main > Options > Verticals - OTM vs ATM vs ITM (time decay and volatility decrease)

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Old Jan 12th, 2009, 12:01 PM   #1
Join Date: Jul 2002
Location: Houston
Posts: 10
Can you guys verify if my thinking is along the correct lines on vertical spreads?

My general strategy: is to swing trade equities, and hold them for about 3 to 6 weeks as an average timeframe. I am usually correct about 75% of the time, within the 3-6 week timeframe. A typical trade might be to buy SPY today, with an exit at 110, and stop at 70. My position size would be to win or lose 5% (if SPY hits my stop at 70, I would lose 5% of my trading account).

Options: I started to buy call options on the underlying equities, as a substitute to reduce overall risk. I had a couple of occasions over the years where the equity would gap down by 20-30%, and I didn't want to expose that much of my account. In the SPY example above, I would usually buy the calls about 4-6 months out to allow enough time.

Since buying calls, my overall performance has not been nearly as profitable. While my win/loss rate on the underlying stock / strategy was about the same. However, when my trade went well, I would only make a 3-4% profit. And if it did not go well, I would lose 6-7%. These were due to the time decay over 4-6 weeks, and usually a small drop in implied volatility (majority was due to time decay).

Now trying Vertical Spreads: So, I wanted a simple strategy with limited risk, limited profit (I always exit at a predetermined point anyway), little risk for early assignment (I don't really want to start selling a lot of options), and relatively neutral to time decay and implied volatility decreases. I am leaning towards doing Long Call Verticals (or Long Put verticals if I think the stock is going down).

My question is: given my underlying stock swing trade methodology described above, is it more optimal to buy OTM vs ATM vs ITM vertical spreads? Playing around on Think or Swim's Analysis page, it seems to me that the optimal strategy would be to buy a slightly ITM call, and sell the OTM call. Thus in the SPY example, I would buy the June 85 calls and sell the June 110 calls. The value of the spread should go up slightly with time decay, and also go up slightly when implied volatility drops a little.

Is my thinking on the correct path here?
Thanks for the help!
Old Jan 12th, 2009, 12:21 PM   #2
Join Date: Apr 2008
Posts: 850
If you want to play the direction of the S&P 500 with options - and this is true of SPY options, SPX options, and ES options - it's important to keep in mind that every time the S&P 500 goes up, IV will drop. And every time the S&P 500 goes down, IV will rise.

There is no more consistent phenomenon in all of trading. So you need to make it work for you, not against you.

That may be why you found it difficult to make money buying calls. Each time the S&P went your way (UP), IV dropped and you made less money than you "should have" made.

You're on the right track with your plan to buy an ITM call and sell an OTM call. That way the IV pattern described above is working for you.

Why? Because if SPY is at 90, and you buy an 88 call and sell a 92 call, the calls are equidistant from the money and thus have approximately the same vega. So overall you are approximately vega neutral.

But if SPY goes down - say to 88 - now your long 88 calls will have much more vega than your short 92 calls. Overall you will be long vegas. And - conveniently - IV will rise, counterbalancing your loss from being long deltas. Nice!

And if SPY goes up, say, to 92? Now your short 92 calls will have far more vega than your long 88 calls. Overall you will be short vega. And lo and behold, IV will go down, increasing your profit from being long deltas. Nice again!
Old Jan 12th, 2009, 12:53 PM   #3
Join Date: Feb 2008
Posts: 142
Quote from ehsuhuang:
Is my thinking on the correct path here?
Thanks for the help! [/B]
Do a google search for "morning market huddle" by Steve Lentz, you can view his archives, he mainly does verticals and occasionally bullish butters and bearish calendars.

BTW; If you're good at swing trading equities, try demo trading Forex, in FX you don't get nasty surprises as in stocks which means you can more less predetermine you ultimate risk as you can with options, plus there are nice trends, and plenty of leverage. Why muck around with spreads and limit your profit potential when you catch a trend? Just a thought

All the best
Old Jan 13th, 2009, 06:13 PM   #4
Join Date: Jul 2002
Location: Houston
Posts: 10
Mr. Consistent - funny you mentioned forex. I traded that about 5-6 years ago when all the internet broker/bucketshops just came out. It was good for all the reasons you mentioned, but it since there are only 5-6 major currencies, the patterns that I was looking for didn't occur frequently enough. I tried daytrading it for awhile, and remember staying up really really late for the London open at 2 a.m. Needless to say, that schedule only lasted for a couple of weeks.

DMO - thanks for the info, and I agree with volatility decreases hurting my strategy. I estimate that the volatility drops have reduced my overall profits by about 10-20%. (And the time-decay reduced it by another 20%). On further analysis, I found a flaw in my verticals plan of buying the slightly ITM call and selling the OTM call. If my underlying trade works out and the SPY goes up from 88 to 100 in the example above, the vertical spread will protect my theta and vega. However, when my trade doesn't work out as expected, and the SPY drops to my stop of 70, both calls are now way OTM and my vertical spread still becomes vulnerable to time decay and volatility decreases.

To put it another way, using an ATM vertical spread achieves my goal of protecting theta and vega for the 75% of my trades that work out. But for the other 25% of my trades that don't work out, the spread is still vulnerable to time decay and volatility just like simply buying a call outright (although slightly less so).

I've though of buying the vertical spread with both calls deep ITM, but the spreads on most stocks are too wide, and the profit factor versus capital at risk becomes much smaller.
Old Jan 13th, 2009, 06:51 PM   #5
Join Date: Sep 2001
Location: Chiberia, IL
Posts: 18,690
Quote from dmo:'s important to keep in mind that every time the S&P 500 goes up, IV will drop. And every time the S&P 500 goes down, IV will rise.

Please stop saying every time. That is simply incorrect.
Old Jan 14th, 2009, 07:15 PM   #6
Join Date: Jul 2008
Posts: 298

Happy new year.

Nitro, you're right but Dmo just can' t stop.
As a former market maker, it's really weird that he never took a look at volatilities for long term options and their behaviours.
If you read some of his posts, he kept focusing on VIX variations and take it as a given for all.
Course it's wrong and everyone who takes the time to look at volatiliIES even on S&P would support this fact. VolatilitIES don't shift the same way, don't react the same time, the same direction.
It would be so easy to make money for market makers if volty markets would behave like that. No research needed and a lot of easy money would be made. Forward volty would be easy (easier) to forcast.

Do you remember Dmo, interest rates CAN'T be negative as you stated. So a delta CAN'T be higher than 1 for vanilla options. And I never read one of your post where you finally agreed it. But reality did.

But Dmo got the right words to be understood by newbies, and this way his contribution is great.
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