Implementing an Option Spread Strategy

When seeking to enter into an option spread, the trader needs to consider a number of factors. An option spread strategy will possess different characteristics at various intervals throughout its life and it is important that these are monitored carefully before execution.

While many cash settlements engage in spreading to reduce premium outlay, the traditional basis of the strategy is in fact to reduce risk. The risk sought to be reduced is not only holistic premium risk, but also the Vega or volatility risk, time decay or theta risk, and of course delta risk. These risks are all related to one another, but individually represent the precise factors that will differentiate one spread strategy at one point in time, from another at a different time.

Most relevant when contemplating a spread is one’s view on volatility. This view needs to be reflected in the choice of strike that is closest-to-the-money. If for example the trader is bullish on volatility, it would be behoove that trader to ensure that the strike price closest to the money is the leg of the spread that is purchased. The closer to the money that an option strike is, the greater exposure that option has to volatility and time decay. Delta risk on the other hand is universally trumped by the option that is most in-the-money., while theta risk or time decay is like volatility, dominated by those options closest to the market; those with the most time value.

Managing each of these contingencies is imperative to making the correct spread trading choice. Due to the superficial similarity between various spread trading strategies, it will be the latent consequences that will serve to haunt the unthinking trader. An addition to the myriad of traps the potential investor may face, once executed the spread trading strategy will not remain static in character; it will change its properties dynamically as the underlying instrument moves in either direction, as the days to expiry approach, and also as volatility fluctuates up and down. Indeed the dramatic changes in store for the spread strategy will become accentuated as premium reduces due to volatility or due to expiry approaching. When premium is high with many months to expiry, or when volatility is high, the Vega risk or risk of volatility risk, and time decay (theta) risk will remain relatively unexceptional if the strikes are nearby. As strike prices get further apart the difference in Vega and theta become more pronounced as they do when volatility is low or expiry approaches.

In many ways, low volatility, expiry approaching and remoteness of strike price have a common thread of differentiation between the strikes of an option spread strategy.

 

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