1. Options Interest Council
Vertical Spreads
A Denver Trading Group
Options Interest Council
presentation by
Ken Sheppard

2. Review of Option Concepts
Leverage
Protection
Getting paid for that protection

3. Key Trade Offs
Potential risk
Probability of profit
Potential profit

4. The Battle Time erosion vs. favorable move in stock price
Fewer days to expiration
Cheaper
Smaller loss
Higher probability
More days to expiration
More time for a favorable move
Less price erosion
More sensitive to changes in IV

5. Intrinsic Value & Time Value
Stock Price = $ 56.00
50-strike Call Option = $
Expiration = 90 days
Time Value = 3.00
Stock Price = 56
Option Premium = 9.00
Intrinsic Value = 6.00
Strike Price = 50

6. Option Pricing Stock Price = $ 56.00
50-strike Call Option (IV = 35) = $
Expiration = 90 days
TV=9
TV=7
TV=5
TV=3
Stock Price = 56
IV=6
IV=6
IV=6
IV=6
Strike Price = 50
Imp V = 35
Imp V = 50
Imp V = 65
Imp V = 80

7. Option Pricing Stock Price = $ 56.00
50-strike Call Option (Exp = 90) = $
Implied Volatility = 35
TV=5
TV=3
TV=2
Stock Price = 56
TV=1
IV=6
IV=6
IV=6
IV=6
Strike Price = 50
Exp=30days
Exp=60days
Exp=90days
Exp=180days

8. Call pricing curve

9. Call pricing curve (cont.)
Time value premium is greatest ATM
Intrinsic value is zero until strike price is passed.

10. Call pricing curve (cont.)
As IV shrinks, the price curve merges with the intrinsic line.
As expiration draws closer, the price curve merges with the intrinsic line.

11. Time Decay
Exp=120days
Exp=90days
Exp=60days
Exp=30days

12. Long Call +5 45 50 55 60 -5

13. Profitability Foremost: Secondarily:
Favorable movement by the underlying
Secondarily:
An increase in implied volatility

14. Which option to buy?
“The shorter term your horizon, the higher the delta should be!”
Day-traders
Use the underlying (2 min to 2 days)
Short-term swing traders
ITM, short-term (2 days to 2 weeks)
Intermediate-term position traders
ATM (2 weeks to 2 months)
Long-term (2 months to 2 years)
OTM, LEAPS

15. The frustration problem
Bid-ask spread
Implied volatility changes
Risk management

16. What is a spread?
A strategy which involves taking simultaneous but opposing positions in different instruments
Being long in the instrument which appears to be under priced
Being short in the instrument which appears to over priced
The trader hopes to profit when the prices return to their expected relationship

17. Why spread? Reduces the effect of short-term ‘bad luck’
Reduces short-term risk
- Natenberg p133

18. Vertical spreads Directionality is the primary concern
Initially bullish or bearish
Remain bullish or bearish regardless of changes in market conditions
Volatility is a secondary concern
At expiration
A minimum value of zero (both options OTM)
A maximum value of the spread (both ITM)

19. Bull Call Spread Sell a call (put) at a higher exercise price
Whenever the trader buys the lower exercise price and sells the higher exercise price, the position is bullish!
Buy a call (put) at a lower exercise price

20. XYZ price at expiration
Bull Call Spread
XYZ price at expiration
Oct 30
profit
Oct 35
Total 25
-$300
+$100
-$200 30
-300
+100
-200 32
-100 35
+200
+300 40
+700
-400 45
+1,200
-900

21. Call vs. spread purchase
XYZ common, 32
XYZ Oct 30 call, 3
XYZ Oct 35 call, 1
Call does better
if price > 36
Spread does better
if price < 36
Limited risk
BE = 32

22. Least aggressive (ITM)
Stock
Larger probability
Smaller potential

23. Aggressive (ATM)
Stock
Substantial returns if
stock price rises

24. Extremely aggressive (OTM)
Stock
Inexpensive
Remote chance

25. Position analysis Theoretical edge Delta Gamma Theta Vega
position will cross current price above zero line
Delta
the slope as it crosses is determined by magnitude
Gamma
‘ + ’ is convex (smiles); ‘ - ’ is concave (frowns)
Theta
‘ + ’ will shift upward over time; ‘ - ’ will shift downward
Vega
‘ + ’ will shift upward with increasing volatility;
‘ - ’ will shift downward with increasing volatility

26. How volatility affects bull spreads
Stock price: 25
Time to expiration: 3 months
Position:
bco at 25
sco at 30
What happens to the price of the spread is implied volatility increases?

27. How volatility affects bull spreads
Stock price = 25
Implied volatility
25/30 Bull call sp
(theoretical value)
Position vega
20%
1.02
3.69
30%
1.31
2.20
40%
1.49
1.25
50%
1.59
0.71
60%
1.64
0.38
70%
1.67
0.17
80%
1.68
0.03
Interest rate = 2.0%, American style expiration

28. How volatility affects bull spreads
If implied volatility is too low
Focus on purchasing the ATM option
(the option whose delta is closest to 50)
If implied volatility is too high
Focus on selling the ATM option

29. Vertical spread summary
Low Volatility
Debit
High Volatility
Credit
Bull
Bull Call Spread
Sell higher call
Buy lower call
Bull Put Spread
Sell higher put
Buy lower put
Bear
Bear Put Spread
Buy higher put
Sell lower put
Bear Call Spread
Buy higher call
Sell lower call
© Gryffindor Global Investments LLC

30. Which spread is best? Determine the time horizon
Decide how bullish or bearish you are
The delta of the spread
The size in which the spread is executed
Focus on the ATM option
Assess implied volatility
If IV is low, buy the ATM option
If IV is high, sell the ATM option
Compare cost to expected return
© Gryffindor Global Investments LLC

31. Rules of thumb Do not rank by max profit potential
This will always be the OTM spreads
Estimate where stock price may advance by expiration
Using a trading system
Using a Monte Carlo simulator, or
Using 2x the time value of the ATM call as an estimate of stock’s advance
Compare cost to expected return
© Gryffindor Global Investments LLC

32. Follow up adjustments Stock falls below long strike
Close spread as a spread transaction 30 DTE
Stock remains below breakeven
Close spread as a spread transaction, or
Sell long call and let short call expire worthless, or
If underlying drops, buy back the short call (< 0.10) & hold the long call, hoping for a rise in price
Stock rises above breakeven, but below short strike
Close spread as a spread transaction with a small profit
Stock rises above short strike
If assigned, exercise the long call to deliver shares for maximum profit
© Gryffindor Global Investments LLC

33. Stops Stock stops Exit at 40% or 50% loss
If spread doubles, sell half for a free trade
Then, implement tight trailing stop
Finally, sell remainder at 80% of spread
Exit debit spreads before 30 DTE
© Gryffindor Global Investments LLC

34. Option Concepts
Leverage
Protection
Pay for protection