Options Trading Mastery: Time Decay And Volatility Trading Opportunities
Topics: options trading, options trading strategies, stock options trading, stock trading1
The terms ‘bull’ and ‘bear’ are often associated with vertical spreads. This leads most people to think of vertical spreads as directional plays, which is true. Vertical spreads can also be used to take advantage of two other potential trading opportunities - time decay and volatility movement.
Using Vertical Spreads to Take Advantage of Time Decay
If you are looking for a fully hedged way to take advantage of time decay, a vertical spread can be an excellent tool. It has a limited profit potential, but a limited loss scenario for both the buyer and the seller.
At-the-money options have more extrinsic value than their similar month in-the-money or out-of-the-money options. Since it is an option’s extrinsic value that decays over time, you can set up a vertical spread by selling an at-the-money option and buying either an out-of-the-money option (creating a credit spread) or an in-the-money option (creating a debit spread). If the stock holds tight to the out-of-the-money option, the option’s extrinsic value will decay at a faster rate than the in-the-money option or out-of-the-money option. This is because the at-the-money option has more total extrinsic value to decay in the same amount of time as the others.
Creating the vertical spread by selling an at-the-money option and buying an out-of-the-money or in-the-money option as a hedge looks like a good idea. Now, there are a couple choices. Should you do the put or call spread? Should you buy or sell it? You should base your decision of what to do on which way you think the stock will move. Although you are playing for time decay and you are assuming an overall lack of movement, you cannot expect the stock not to move at all. So even though you are playing time decay, you still want to form an opinion on in which direction the stock is most likely to move. Doing this, you have now given yourself another way of making the trade profitable. You are playing for a lack of movement but now you can still win if you pick the right direction. This scenario presents you with two ways to win and only one to lose.
Now that you have picked which at-the-money strike you are going to sell and you have picked your anticipated stock position, you still have a decision to make. Do you do the call vertical spread or the put vertical spread? Remember, both the vertical call spread and vertical put spreads allow you to participate in either stock direction. For the bulls, you can buy a vertical call spread or sell a vertical if you think that the stock will go up.
For the bears, you can buy a vertical put spread or sell a vertical call spread.
There are two choices to decide from for each direction. One is a purchase. The other is a sale. The best way to decide which one to do, other than your own style or comfort, is a simple risk/reward analysis. By selecting an at-the-money option to sell as part of a vertical spread, an investor can execute a time decay play with a hedged position.
Using Vertical Spreads as a Volatility Play
Vertical spreads are also usable as a volatility play. We stated earlier that an at-the-money option has more extrinsic value than other options in its expiration month. This is due to a number of contributing factors including time and largely volatility. An option’s dollar sensitivity to movements in implied volatility is known as Vega. Obviously, an at-the-money option will have a higher Vega (volatility sensitivity) than an in-the-money or out-of-the-money option in the same month.
As volatility increases, the at-the-money option will increase in price to a greater degree than will an in-the-money or out-of-the-money option. As volatility increases, the at-the-money option will increase in price to a greater degree than will an in-the-money or out-of-the-money option with a lesser Vega.
Conversely, the at-the-money option will lose value at a greater rate than an in-the-money or out-of-the-money option should implied volatility decrease. The question is how to use the vertical spread to take advantage of anticipated movements in implied volatility. Remember, the vertical spread affords you the luxury of being hedged on either side of the trade - both as a buyer and as a seller of the spread.
If you think that implied volatility is likely to increase, you can set up a vertical spread by buying an at-the-money option and selling either the in-the-money or out-of-the-money option against it. If you feel that implied volatility will decrease, you can set up a vertical spread by selling an at-the-money option and buy either an out-of-the-money or an in-the-money option against it.
To set it up, you would follow the same guidelines for setting up a vertical spread to take advantage of time decay. Decide which direction you feel the stock would most likely move. If you feel it is likely to rise, you must decide between buying a vertical call spread and selling a vertical put spread.
Either way, the spread will have to be constructed with the at-the-money option being long if you feel volatility will increase or short if you feel volatility will decrease. If you feel the stock would most likely fall, you will have to decide between buying a vertical put spread and selling a vertical call spread. Either way, the spread must be constructed with the short option being the at-the-money.
As you can see, the vertical spread is not restricted to directional scenarios. It is very versatile allowing the investor several choices among a diverse group of potential uses. It also affords limited risk, albeit limited profit potential, to the buyer and the seller.
Ron Ianieri is currently Chief Options Strategist at The Options University, an educational company that teaches investors how to make consistent profits using options while limiting risk. For more information please contact The Options University at www.optionsuniversity.com or 866-561-8227
Previous Articles Highlighter:
Be More Available To Your Customers (1)
Hustead, bothered by the sound of cars on the nearby highway heading for Mount Rushmore, persuaded her husband to expand their business to serve these travelers. Mr. Hustead put up signs on the highway to draw visitors to their store, making a unique appeal.
The ECOnomics Of "Green IT" (2)
On top of that, the initiatives earned nearly $1 million in rebates and awards from Silicon Valley Power. What are the best practices in green computing? In August, the Environmental Protection Agency issued a report at the behest of Congress recommending ways to reduce energy costs in data centers.
How To Perfect Your Putt So You Are Putting Like A Pro (3)
Putting is probably the hardest part of golf that you will have to learn how to do. For some it's easy but others a disaster. You will need to learn how to hold the club when putting and then learn how to make the putt itself.
How To Find The Proper Engagement Gift (4)
Special occasions imply offering amazing gifts and lots of smiles but actually choosing a certain gift may be difficult. One such wonderful occasion is when two of your friends get engaged.
Greening Your Child's Wardrobe (5)
A product I like to use is Simple Green. It's available at many grocery or Target-type department stores. It's nontoxic and biodegradable, so meets a lot of my standards for a good cleaning product.
Foreclosure Pitfall: Private Investors May Cost You Your Home (6)
If you are facing foreclosure then this may be good news, however beware of the dangers, and investor that has interest in your property, may adversely affect you in the even that they get into financial trouble.
How To Choose The Right Formula Drifting Tires For Your Vehicle (7)
As a reward for their sponsorship, they get to market their special tires. This article will discuss some of the most popular manufacturers to distribute drifting tires for regular vehicles.
A Great Tool For Increasing Your Personal Productivity (8)
Topics: hitch cargo carriers, hitch mounted cargo carriers, hitch mount cargo carriers As people start a new year with new goals and resolutions, they'll inevitably look at the previous with one big question on their mind: What happened?
Having A Couple Of Home Based Businesses Can Make You Rich (9)
Most losers have no plan or they have a plan which is wrong or ineffective. Many people fail to get ahead in life because they have the wrong plans.
Creating Spin-Off Websites For Internet Income (10)
This type of a website gets its start by publishing content on the Internet that responds to, criticizes, questions, or debates the material of other, more popular web pages. In most cases, when visitors consistently go to a web page that they do not necessarily agree with or have questions about, they will truly enjoy visiting another site that does address their needs or concerns.
Newer Articles Highlighter:
Taste The Difference At Florida's Finest Restaurants (1)
Italian food is known everywhere around the world! maries italian kitchen was most probably the best italian i have ever ate, loved it. esca restaurant and martini bar: Enjoy Italian French fusion in the downstairs dining room.
How To Purchase Gemstones On The Internet (2)
I encourage you to put this "purchasing model" in place to avoid the common pitfalls and disappointments of making incorrect buying decisions on your next gemstone purchase. Give it a try!
Making Money The Old-Fashioned Way Or What (3)
To prove this, ask yourself a few of the following questions and physically journal your answers. Who am I in my career? Do I have a career purpose?
Will The Complete Accounting Software Work For You? (4)
It can store information on the amounts of inventories you have, and provide an in depth analysis of the stocking requirements. You can also make predictions about how much inventories you will require to fill your orders.
Star System Of Hollywood Movies (5)
It was known that the MPPC did promote some actors during that time. There was gradually a change in the star system of Hollywood movies, and the main reason for this was that the public wanted to know the real name of the actors.
Repairing A Home Before Sale (6)
If the Section 1 repairs are minor, consider having them done. It's a nice bullet point in the marketing - Includes Section 1 Termite Clearance! - especially because not all homes will have this.
Tanzanite Prices, Where Will They Go From Here? (7)
Most of the material presently coming out of the ground is of much lower quality than what has been available for a fair price in the past. Suppliers have been pressed from all of their vendors to continue to maintain a firm line on price, yet continue to provide good color.
VoIP Vs. PBX - VoIP Is Winning The Battle (8)
When call from your home, the utility sends your call over the lines to the line of the person you are calling using the central office locations. To make this happen, the phone company uses a Public Switched Telephone Network, or PSTN.
Social Bookmarking: Another New Internet Marketing Tool (9)
The site is constructed so that everyone who visits can see your favorites list and can visit the sites that you think are important. Visitors to your social bookmark list not only can visit your favorite sites, they can add the sites that they like to their own social bookmark list.
Search Engine Optimization (SEO) Basics (10)
Again don't spam the text with keywords. In most cases if your content is on your keyword subject, the keywords will end up in the text naturally. SEO is not an exact science.
Permalink to Options Trading Mastery: Time Decay And Volatility Trading Opportunities