Can vertical spreads be used during low volatility? More simply, what kind of spread benefits from low premiums?
So I'm trying to find the difference between Bull call spreads and Bull put spreads (and Bear spreads) in relation to Implied Volatility. PCLN May Long 540 call $30.40 Short 545 call $26.50 vs Long 540 put $21.60 Short 545 put $23.50 With the call spread, your profit comes from the long option being exercised. Contrarily, with the put spread, your profit comes from you short position expiring worthless. Does this tell us that spreads can be used for both buying and selling? Wouldn't that make it possible to make money when options are under priced as well as over priced?
If options are priced fairly, there's no difference in the P&L of equivalent spreads. To see this, graph a position where you you buy the bull spread and buy the equivalent bear spread. The result will be a horizontal line near zero (any small distance away from zero will be from associated carry cost). If options are mispriced, floor brokers will get them long before you even see them. When closing long options, if time premium remains, better to sell than to exercise. If long option trades below parity, can be better to exercise. If broker provides free assignment and exercise, may be better to exercise. Best answer is compare the slippage and commissions and go the cheapest route. If bullish, put spread better than equivalent call spread since if right, options will expire and no closing costs (B/A spread and commissions). Opposite is true for call spreads (sell to open if bearish).
1) In a "low" volatility environment, the volatility skew will be "flatter". 2) You'll pay "less" for one option with respect to another option at an adjacent strike price. 3) Option premiums are neither underpriced nor overpriced in the market.
At the same pair of strikes prices the two spreads are identical in all respects. The relationship that holds them together is called a Box spread and this relationship is rarely out of line, and even if it gets out of line it is arbed instantly by the market makers and institutional traders so you don't have a chance here. However, generally, it is easier to get a slightly better fill on an OTM spread than on an ITM spread. So you should aim for the OTM one, but it is wise to always check the counterpart to see if you can get a better fill there. OTM long spreads and ITM short spreads are long volatility. ITM long spreads and OTM short spreads are short volatility.
What do you mean by this? So if the goal is to be selling when volatility is overpriced and buying when it is over priced, can't we use debit spreads, as in Bull call spreads, to buy, and credit spreads, bull put spreads, to sell? So if you think premiums are overpriced, you should set up a bull put spread. But what if a bull call spread gives you a better risk profile? Does that mean that you should be buying?
You are missing the point, a bull call spread and a bull put spread at the same pair of strike prices are synthetically equivalent, i.e. they are identical in all aspects. So it doesn't matter whether you trade one or the other, your position and sensitivity to changes in price, implied volatility and other variables would be exactly the same. Only when the two spreads have different strikes prices do they start to differ.
I know, they are identical in all aspects, but how come one will give you a better risk profile than the other sometimes? Shouldn't they always be the same if they are identical in every way? I think something can be deduced from their differences. edit: With the example I posted earlier PCLN May Long 540 call $30.40 Short 545 call $26.50 vs Long 540 put $21.60 Short 545 put $23.50 If you were to trade both using one contract each, you would get the following numbers. The Bull Call Spread would have a max profit of $110, and a max loss of $390. The Bull Put Spread would have a max profit of $190, and a max loss of $310. So, we can easily conclude that the bull put spread is the better of the two trades. Doesn't that tell us that is is better to be collecting premium than buying for this underlying?