A popular feature of spread selection is the assumption that mispriced options are found frequently. This observation leads to a natural conclusion, that is makes sense to take up a market position opposing the option while, at the same time, entering a position in the option. This popular hedge may involve trading in the underlying, or in other options that are equivalent to positions in the underlying. In this way, the volatility spread facilitates risk management while also exploiting a mispriced option.
Beginning with a study of delta, how can a trader hedge an underpriced option? There are several ways. If, for example, the first step is to buy 3 options, they can by hedged by: (a) selling 300 shares of the underlying, (b) buying puts with the same or similar delta, (c) selling calls of a different strike and with the same delta, or (d) combining the above moves in ways that create the same delta as the original long calls.
In setting up a volatility spread in one of several methods, the outcome creates several attributes that are shared by the strategies themselves. These include al overall delta neutral result, sensitivity to any price change in the underlying as well as to changes in implied volatility, and time decay that affects both sides of the spread equally (and based on amount of time remaining to expiration).
This last attribute, time decay, can lead to some interesting variations in the volatility spread when it is set up horizontally (different expirations) or diagonally (different expirations and strikes) rather than vertically (same expiration and strike). This adds great variety in how a volatility spread can be created. Among the consideration are collateral requirements, cost of the underlying when held or traded, and richness of premium on either long or short sides.
The selection of a volatility spread is complicated by the possibility of many different ones. The range of spreads includes:
Ratio backspreads (also called long ratio spreads) – combining a greater number of long options than short, with the sale expiration. The long positions should have higher delta value than the short positions. Either calls or puts can be used.
Ratio vertical spreads (also called front spreads or short ratio spreads) – This involves a higher number of short positions than long positions, all with the same expiration.
Butterfly and condor spreads, either long or short – unlike basic two-position spreads, butterfly and condor spreads involve more complex multiples, and may be either long or short. Butterflies involve three strikes, and condors use four.
Calendar spreads (horizontal or time spreads), long or short – the strikes are the same on both sides, but expiration is not. Typically, the shorter-term strikes are short and the longer-term are long. This exploits more rapid time decay on the short side, but it sets up a net debit.
Diagonal spreads (different expiration and strike) – in this variety, both strike and expiration are different. It is set up to exploit expected underlying movement as well as time decay. Shorter-term are normally short, and longer-term are long. By using different strikes, the net debit can be reduced or largely eliminated.
Ratio calendar or diagonal spreads – varying the number of positions in calendar or diagonal spreads allows an otherwise net debit to be converted to a net credit. Using shorter-term short options greater in number than longer-term long options, risks are manageable. Movement to ITM is managed by rolling forward and creating a different version of the volatility spread.
Collar – in this volatility spread, three positions are opened. They are a long position in the underlying, a short covered call, and a long put. The call’s strike is higher than the cost of the underlying, and the put’s strike is lower. This position makes sense when the original cost of the underlying was well below current market value.
Gut spread (both sides in the money) – this spread assumes the underlying will move significantly before option expiration, but the trader is not certain about the direct of the price movement.
- Synthetic long and short stock – these consist of one long and one short option, which in combination mirror movement in the underlying security. A long stock synthetic consists of a long call and a short stock; and a short stock synthetic is made up of a long put and a short call. The net cost to open this position is close to zero if the strike is close to the money. The combined change in net value will track the underlying point for point.
Given the many variations in the volatility spread, traders must be especially concerned with the degree of movement in the underlying. In the ideal hedge, the direction of underlying price change does not matter, because one side offsets the other. Most volatility spreads will perform better when movement takes place in a desired direction. But even in the perfect hedge, a large movement can create either exceptional profits or losses, as well as undesired changes in the collateral requirement.
This is especially concerning to traders using multiple contracts on either side, when a large underlying movement could outpace available capital, resulting in having part or all the position closed due to shortfalls in collateral. This may present a more serious risk than the option-related profitability of a spread. Even so, the unintended consequences that are always possible, may be overlooked by edging traders, or by those spending too much focus on delta and gamma and not enough on more basic matters, such as historical volatility.
Volatility spreads are appealing as hedging instruments, but they also come with many risks, including some not apparent when first considered. The trader who is aware of the importance of volatility in all spreads, is more likely to also be aware of a full range of risks.
Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his website at Thomsett Publishing as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.
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- Fundamental Volatility and Stock Prices
- How to Trade Options Volatility
- Volatility During Crises
- How To Profit From A Volatile Market
Original source: https://steadyoptions.com/articles/managing-volatility-spreads-r611/