Intricacies of Option Spread Trading
Spread trading with options may appear fairly straight forward; even rather attractive due to its risk aversion properties however, as often the case with serious investment; not all is as it seems.
Options like any capital asset are valued according to their future returns, or more precisely, the probability of future returns. According to market perception the forces of demand and supply will manipulate the price of an option, regardless of what a mathematical pricing model suggests.
In this event, the concept of a linear benchmark for annualized option volatility is found to be sorely wanting. Similar to other capital investments whose future earnings are diluted by an increased likelihood of lower spending power, option prices will ultimately be at the mercy of market forces who at times may value the likelihood of returns to be quite at odds with linear projections.
Of course the experience of human nature is of invaluable assistance in this scenario. Many markets behave in precisely the same fashion each time they undergo a uniform shift of similar variety. It is in this observation that spread trading can be maximized to exact value. As markets rise, volatility often plummets as assets are often far slower to appreciate in value than depreciate. This observation would dictate a spread that leaves the trader with a short volatility position as the market rises. Conversely, markets fall with gusto and so remaining long volatility in anticipation of a downward shift will leave a portfolio long when the market retraces and volatility rises without exception. In these sorts of environments, traders need to apply the above strategy to spread trading around the money. The greater the distance between the strike prices, the greater a skew will develop in the market to reflect various volatility differences between strikes. Mathematically, the skew is irrational as often the trader will pay a higher volatility for the long leg of the spread than receiving for the short leg. However, in reality the trader will profit as mathematics is merely art, whereas market fluctuations and human responses are life. With option volatility, art does not replicate life.
When strike prices are come closer together in spread trading, the skew necessarily needs to reduce; proximity breeds familiarity with options, and so care must be taken to avoid excessive zeal in applying a skew principle. Particularly as the strike prices in a spread strategy approach the at-the-money strike, care ought to be taken to incorporate the volatility consequences of the strategy along with future market inevitabilities.



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