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)
A young married couple, Mr. William and Ms. Dorothy Hustead, bought a small store in a tiny town near the South Dakota Badlands. From 1931 to 1936, they struggled through the Depression serving the town's 326 impoverished residents.
The ECOnomics Of "Green IT" (2)
In the past, CIOs often had no idea about rising energy bills until power and cooling issues prevented them from adding servers to the data center. That is changing quickly.
How To Perfect Your Putt So You Are Putting Like A Pro (3)
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)
Why not ask friends to combine funds so you could all give the couple something they really need and want? The new couple has just bought their first home and need furniture; fund their desires with the help of friends!
Greening Your Child's Wardrobe (5)
Buy organic if the budget allows. Considering the cost of most organic clothes, this really won't work for every family. But it's worth mentioning. Besides, I figure that using used clothes means your clothes are pretty green right there.
Foreclosure Pitfall: Private Investors May Cost You Your Home (6)
Having a property foreclosure will affect you for many years in the future. Make a valid effort in protecting yourself from a home foreclosure if possible. There are is a growing number of real estate investors that would gladly place their money into your property in efforts to grow their financial portfolio.
How To Choose The Right Formula Drifting Tires For Your Vehicle (7)
Other Lesser-Known Manufacturers Several other lesser-known tire manufacturers also distribute Formula Drifting tires. Examples of these manufacturers include Dunlop Tires, Cooper Tires, Toyo Tires and Falken Tires. You can find more Formula D tire manufacturers by searching for them on Google or investigating what is said in automobile racing magazines.
A Great Tool For Increasing Your Personal Productivity (8)
Think of the final result you want to enjoy, whether it's losing twenty pounds, paying off your credit cards, or getting an extra $2,000 in the bank. Break up your big goal into smaller goals and tasks that will help you achieve your goal result.
Having A Couple Of Home Based Businesses Can Make You Rich (9)
Every owner has ups and downs. The winners shake off the losses and keep going. Winners refuse to quit no matter what may happen and no matter how long it may take for them to achieve their goals.
Creating Spin-Off Websites For Internet Income (10)
People like to learn about new things and quickly change their minds about a lot of topics. Increasing the flow of Internet traffic is able to be achieved through the startup of successful spin-off sites.
Newer Articles Highlighter:
Taste The Difference At Florida's Finest Restaurants (1)
i loved eating in this restaurant it made a nice quiet change to the loudness of other restaurants in florida. Marie's Italian Kitchen: Marie's Italian Kitchen opened in September 1997.
How To Purchase Gemstones On The Internet (2)
Didn't read the "fine print" regarding my gemstone purchase... Wanted to return the gemstone and the seller charged a hefty re- stocking fee... Didn't understand the importance of clarity,tone, hue and saturation before making my gemstone purchase...
Making Money The Old-Fashioned Way Or What (3)
Am I discontent with my present earnings? Am I committed to doing what is necessary to obtain a better career with better earning's potential? Am I willing to commit to changing my career path to make better money?
Will The Complete Accounting Software Work For You? (4)
The complete accounting package is advanced level software for business accounting. As such, it has features for maintaining the accounts of small scale as well as great scale businesses.
Star System Of Hollywood Movies (5)
He got hold of Lawrence from Biograph and spread a rumor that she was killed at a car accident but then later combated this rumor and said she was doing fine and would be starring in the up-coming film produced by him.
Repairing A Home Before Sale (6)
If you feel that your ideal buyer is someone who knows that few homes have Section 1 clearance, just market your home with the cost of needed repairs factored into the price.
Tanzanite Prices, Where Will They Go From Here? (7)
In summary, the tanzanite market has changed substantially since 2004. If you are in the market to add any loose tanzanite or tanzanite jewelry to your collection, it is recommended that you do so immediately so as to have the best chance at obtaining this important gemstone at a value price, even at $600+ per carat.
VoIP Vs. PBX - VoIP Is Winning The Battle (8)
This is a VoIP system. What is VoIP? VoIP is the acronym for "Voice Over Internet Protocol." Protocols are the policies for how all things related to the Internet should work.
Social Bookmarking: Another New Internet Marketing Tool (9)
A few popular sites are: del.ico-us, backflip, netvouz, Digg and stumbleupon. Getting involved in social bookmarking is good internet marketing, taking advantage of the interactivity of Web 2.0. Social bookmarking is one more tool to use to boost your sites popularity and increase traffic.
Search Engine Optimization (SEO) Basics (10)
That means not only does it need to include your keywords, but it needs to be compelling enough or direct enough for someone to click on it when they see it.
Permalink to Options Trading Mastery: Time Decay And Volatility Trading Opportunities