With a recent downward volatility movement, it makes me think of a possibility of a movement in strategy in regard to spreads.  At this point, I’ve still been pretty vertical in my spread selection, but that may change soon.

Let’s start by going over what a vertical spread is.  A vertical spread is when you buy an option and sell an option on the same underlying for the same expiration with different strikes.  It can be bullish or bearish.  The spread can be long or short.  It can be for income or it can be for a directional play.

A horizontal spread is when you buy an option and sell an option with the same strike price but with different expirations.  This can be bullish, bearish, or neutral.

A diagonal spread is when you buy an option and sell an option with different expirations and different strike prices.  For today’s article, we will lump diagonals and horizontals in the same space.  Yes, they are very different trades, but for the purpose of this article, they will have the same effect.

The benefit of using a vertical spread is that volatility can be taken out of the option pricing equation a bit.  In other words, if volatility hurts your long option, it will benefit your short option and vice versa.  It will never totally be a non-factor, but it can definitely be less of an influence.  By buying a vertical spread, there is typically much less volatility risk than buying a single leg option.  I typically like to use vertical spreads when I believe implied volatility is higher.  In other words, if I’m concerned about implied volatility going down, I will not touch a horizontal spread.

The reason is as follows….when you buy (or sell for that matter) a vertical spread, you are locking in that expiration’s volatility.  You are also neutralizing it (not totally, but it can be significant depending on how you set up the spread).  So, if implied volatility drops, you will not be hurt quite as bad with a vertical on.  If it rises, it won’t benefit you much either as both options will have different reactions.  This is assuming all other option pricing factors remain constant.

In regard to a horizontal spread, you are locking in implied volatility for those months.  For example, if you buy a 6-month call option and sell a 1-month call option against it, you risk implied volatility dropping the next month.  In other words, if you liked the credit you got on the 1-month call option, you may not like it the next month if IV drops.  It won’t be as much.  Also, your 6-month call option will lose some value as well (assuming all other factors remain constant).  So, by using a horizontal spread, you risk a drop in implied volatility.  That is why I only like to trade horizontal spreads when I believe volatility is low.  Conceptually, these same things would apply to a diagonal spread as well.

If God were to tell me that implied volatility would stay the same or increase, I would use horizontal spreads all the time.  However, since God doesn’t give me direct trading advice, I try to use my knowledge of where I think implied volatility is going to make a decision on the best spread to use.

Finally, I want to address the question of what to do if you are not sure of the direction of volatility and you don’t want to take a position on it.  You just want to trade the direction of the underlying.  Whenever I’m in that situation of sentiment, I typically go with a vertical.

For more information on what I do as a financial advisor, send me an email at mtosaw@stcharleswealth.com.