subscriber asked about call spreads, specifically vertical spreads and diagonal spreads. In some of the comments Skip Raschke did a fine job of describing some of the "mechanical" ideas behind spreads. Namely how they work. What I want to focus on here are the more fundamental (by that I mean volatility) reasons for why you would want to trade a spread and another layer of understanding in how they are priced.
First off, the market will provide "edge" in pricing, sometimes. By that I mean a difference in the volatility numbers of two separate option contracts. For instance, you see Henry Schwartz and Mark Sebastian discussing unusual activity. The simple demand for an options series (ie. big call buyer) pushes up the relative implied volatility of that option higher than all the others in the same expiration month. What that does is make the cost of a spread go down in premium paid and decreases the risk of the trade. So a good way to buy a vertical call spread (or put spread) is to buy the cheaper implied volatility strike and sell the more expensive volatility strike. The market is actually paying you to do this and it is hard to find for call spreads. Volatility edge exists naturally in put spreads because of the skew in the market (I have recommended several 1x2 put spreads based on this).
The same volatility edge can apply for a diagonal call spread. Stock movement can push up the implied volatilities of near-team options much higher than the second expiration month. For a diagonal call spread, this could set up a relatively cheap entry point since the front month out of the money option you are selling will help finance the back month more in-the-money option you are buying. Diagonal spreads are also nice to consider two weeks to expiration in the front month because of accelerated decay. The front month will decay much faster than the second month and makes for a good setup (also consider same strike time spreads).
Keep in mind when you start to learn about option implied volatility you should ask yourself, "why is the pricing like that?" The put skew exists naturally (that means out-of-the-money puts will almost always have higher implied volatility than more in the money puts) because the fear is in the meltdown. For the CBOE Volatility Index VIX (and options on commodities), the skew is in the calls and not in the puts because a market meltdown (or supply panic in a commodity) means an explosion in the price of the VIX. Think of mild panic as always being priced in. Mark Sebastian created a nice little indicator for measuring a variation of this.
Volatility edge (option to option) is one factor (by far the largest) in my trading recommendations. The most important part of a spread is risk control. For a long call spread, if you want the position (there are many other reasons), you are almost always giving away some edge to the market in return for lower risk. All the Greek risks (delta, theta, vega) are reduced by a spread. By understanding the implied volatilities in the option series you have a window into what is going on in the name and future expectations of price movement (remember both up and down). That is information the market gives you and the more information the better.
Special Invite to the Floor of the NYSE: Join Skip Raschke, Jill Malandrino and OptionsProfits for exclusive access to the to the NYSE trading floor. Skip and Scott Redler of T3Live will provide informative presentations on trading and the markets in the Exchange's main boardroom. Following the session, we will head to the trading floor for a mock trading session and cocktail reception. This is an amazing opportunity that you will not want to miss!
Andrew is the Executive Vice President of Business Development for Aqumin, where he participated in the design team to apply AlphaVision to the financial markets. For 15 years he was a member of the Pacific Exchange and the Chicago Board Options Exchange, where he actively made markets and traded in both equity and index options. At the same time Andrew started and ran the Designated Primary Market Marker post for Group One, Ltd. on the floor of the CBOE where it became one of the highest grossing posts for the company in 1992 and 1993. While in Chicago and San Francisco, Andrew was instrumental in creating and managing a training program that allowed Group One, Ltd. to dramatically increase its trader count over an eight year period. He left Group One, Ltd. to co-found Henry Capital Management in 2001.
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