|Strategy||Manange Winners||Optimal Days to Expiration||Entry|
|Short Vertical Spread||50% of max profit||45 days||Month Start/End|
|Time Spread||25% of premium paid||20-30 days||Mid Month|
|Long Vertical Spread||25% of max profit||90 days||Anytime|
Option Spreads Strategy
- Vertical Spread (money spread)
- Time Spread (horizontal or calendar spread)
- Diagonal Spread
If the spread strategy increase in value as the stock price increases, it is known as the bullish spread.
Likewise for the strategy which increases in value as the stock price decrease, is known as the bearish spread.
Holding two options position (of the same type, call or put option) with a different strike price, same expiration date.
Each option position in a vertical spread is referred to as a leg.
There are 4 types of vertical spread.
Short vertical spread:
Aim is to go into OTM
- Short Call Spread (or Bear Call Spread)
- Short Put Spread (or Bull Put Spread)
Long vertical spread:
Aim is to go into ITM
- Long Call Spread (or Bull Call Spread)
- Long Put Spread (or Bear Put Spread)
We apply short (selling) vertical spread when Vega (volatility sensitive) is high. Ideally closing our position when vega is low.
We apply long (buying) vertical spread when Vega is low. Ideally closing our position when vega is high.
Bull Call Spread -> https://www.youtube.com/watch?v=r5J9jqT7W00
Idea of Short Vertical Spread
The main idea of selling a vertical spread is to sell the volatility. Time decay is negligible because of the spread. We sell a vertical spread when volatility is high. It is a directional trade. We want the spread to go OTM, earning the extrinsic value (earning the premium). Usually we sell vertical with 40-45 days to expiration, which is about the end/beginning of the month. The spread chosen is about 0.3 delta which gives us a 70% probability of success. 70% is about 1x SD (standard deviation move) which is a typical stock movement deviation. This also means there is a 70% chance that it will be OTM at the expiration day, and 140% chance of OTM before the expiration day. Manage profit at 50% of max profit.
- High volatility
- 0.3 delta (Both short and long leg OTM, short leg is the main driving force)
- 45 days to expiration
- Exit at 50% of max profit
Idea of Long Vertical Spread
When volatility is low and we have a directional bias on the underlying stock, we will buy a vertical spread. We want the spread to go ITM, and reduce the extrinsic value. So we open our position at the ATM (at 0.5 delta), buy 1 strike ITM, sell 1 strike OTM. Through my experience, it is better to buy the spread with 3 months (90 days) to expiration because the theta (time decay) will be negligible (decay is highest when it is ATM too). This means that if the stock price direction goes against me, my loss will be lesser (linear risk profile curve). Long vertical has a 50% chance of ITM. Manage profit at 25% of max profit.
As this spread will be ITM, it is important to close the position (ITM short leg) before the earning is release. For index position, be sure to exit before the quarterly expiration (Triple Witching Day). If the position is ITM during the earning announcement, the options may get exercise and the broker will start working on the assignment during the market closed hours.
- Low volatility
- 0.5 delta (ATM, short OTM and long leg ITM, long leg is the main driving force)
- 90 days to expiration
- Exit at 25% of max profit
Time spread is use when the underlying stock is not moving much, and the volatility if low.
Holding two options with a same strike price, different expiration date. This strategy is to sell the near month options (profit from the time decay), and cover long with the far month options. The long position is to cover the short position so that the short is not naked.
Premium paid must not be more than 50% of the cost of the short leg. This is because in a month’s time, the short leg will go to $0 and the long leg is expected to be a value of the current short leg value. This will be an estimate of the price you can sell off this calendar spread.
Profit is managed at 25% of the premium paid for this calendar.
- Low volatility
- 0.5 delta (ATM, or middle of the stock price range)
- 20-30 days to expiration
- Premium paid < 50% cost of short leg
- Exit at 25% of premium paid
Holding two options with a different strike price, different expiration date.
OPTIONS101. Don’t pay more than 75% of the distance of the strike. Short leg OTM a delta 0.33, Long leg ATM.
Iron Condor is simply a pair of short vertical call and put.
Iron Condor -> https://www.youtube.com/watch?v=UPdhRoiIWEY
Moving into Undefined Risk & Other Strategies
The following will help to remember the new undefined risk strategies.
|Defined Risk||Undefine Risk Version|
|Short Strangle is similar to Iron Condor except that there is no Long Options on both endsto limit the risk.
Strangle – to prevent the continuance, growth, rise, or action of; suppress:
|Short Straddle is similar to Iron Fly except that there is no Long Options on both ends to limit the risk.
Straddle – an act of sitting or standing with one’s legs wide apart.
|Ratio Spread is similar to Broken Wing Butterfly except that there is no Long Options on one end to limit the risk.|
At a Glance – Other Various Type of Spread
Some Notes on Hedging
- Use far month options to hedge so that the option premium is not badly affected by time delay.