Choosing a New Options Spread

Moving Up the Skew

Here's something beyond the basics. Moving beyond the basic price prediction, one can consider the skew (the difference in implied volatility as you move up the option chain) to determine if a credit or debit spread makes more sense.

In a normal skew, the lower-priced strikes will have a higher implied volatility, be it a put or call option. A vertical skew means that implied volatility increases the further out of the money you go. A vertical skew is uncommon in individual stocks; it will generally appear in high volatility situations around takeover rumors or impending news events. But a vertical skew is often seen in index products and occasionally on broad-based ETFs.

This is noteworthy only in that it presents a situation in which the debit and credit spreads have similar risk/reward but will have a different vega (the expected change in an options value for one unit change in the implied volatility).

When volatility is high and there is a positive skew, it makes sense to use a credit spread because it will benefit from a decline in volatility. A debit spread expects a strong directional move and is not negatively impacted by an increase in volatility.