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Efficiently Trading Option Spreads

Many investment newsletters and option strategy resources tout put-spreads and call-spreads as the two fundamental option strategies.  In doing so, they often tell retail investors to do exactly the wrong thing.  In a world of flat volatility curves, I do not care what you buy and sell in the option arena.  Unfortunately, volatility curves are anything but flat and it makes a very big difference if you pay attention to the curves.

When selling naked options to earn premium many investors are very scared of the unlimited risk.  If you sell a call option at a strike of $50 the stock could theoretically go to infinity before expiration.  When selling a put option with a strike of $50, the stock could theoretically go to zero and you would lose $50.  The strategy that many option experts suggest is to sell a spread.  Instead of just selling a put at $50, you also buy a put at $45 or $40.  That way you can not lose more than the gap between the two strikes.  If you sold a $50-$45 put spread you are only on the hook for paying out $5 because for every point below $45 you make an offsetting dollar on the put that you purchased.  This is sold to retail investors as a way to mitigate risk and get rid of the possibility of large losses.

In following this recommendation, many retail investors are doing exactly the opposite of what I would like to see them do.  In general, equity options exhibit a smirk, or negative skew.  This means that options at lower strikes have higher implied volatilities than options at higher strikes.

Options with lower strikes have higher implied volatility

What this means for the put spread seller is that he is buying an option at a higher implied volatility than the option that he sold.  In every post about options I always emphasize that you want to sell at high implied volatility and buy at low implied volatility.  If the strategy forces you to do the opposite, then you should reassess your strategy.

In order to make this post complete,  I will list the spread strategies that make sense given the shape of the implied volatility curve in the market that you are trading.

Now think of how you would trade ratio spreads using this same methodology…


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7 Responses

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  1. ngbstl says

    Enjoyed ur article. Question: couldn’t an argument be made that it IS indeed a worthy trade-off to have the farther-OTM long leg of your spread be higher IV than the short leg, in exchange for limited and defined and manageable risk? (vs risk of naked sales?) thx for ur feedback!

  2. SurlyTrader says

    Of course all situations are going to require some risk/reward tradeoff analysis. This article should only be used as a rule of thumb rather than a definitive guide to trading spreads. You are right though, if I was selling naked options on a stock and felt that the risk of a very large event was likely and I did not want to be exposed to that binary outcome then I might look for ways of protecting myself using long option positions even though the implied volatility of the purchased option would be higher than the written option. I might also use a ratio spread to mitigate the fact that I was purchasing higher implied vol. Investors who always use spreads when selling options should tighten up their stop losses and selling discipline rather than giving away valuable premium by buying option protection.

  3. David Lockwood says

    I understand your point, and I’ve been very mindful of this problem, especially in my Iron Condor strategies. Ultimately, though, I can’t ignore the benefits of reduced margin. My modeling suggests the tradeoff between lower premiums and lower margins is worth it……..

  4. SurlyTrader says

    That is a great point. In certain circumstances it is better to reduce the required margin on the trade and give up a little bit of the profits, especially in highly leveraged portfolios. One way to get around this is to have naturally offsetting positions when portfolio margin requirements are available versus trade margin requirements.

  5. Timorous says

    Good analysis, Surly. I wonder though, about the smirk, and how seriously alert traders need to take it. Not that it is unimportant, but given the trade offs mentioned by ngbstl and Lockwood, and the fact that implied volatility is just a mathematical construct, should we really let it guide our trades? I say this primarily because early in my trading career, I followed some professional advice and based a trading system on this very discrepancy – trying to take advantage of the smirk. Turns out that was a mistake, and I had my tuchus handed to me! :) So perhaps the higher implied volatility doesn’t really hurt us too much?

Continuing the Discussion

  1. Negative Gold Skew | SurlyTrader linked to this post on February 10, 2010

    […] calls on gold to take advantage of the negative skew.  If this strategy confuses you, make sure to learn how to trade options efficiently. Share and […]

  2. Trading the Negative Gold Skew | Global Investors linked to this post on May 18, 2010

    […] If your view is still negative on the dollar, this means that a purchased call has gotten cheaper relative to a put. A good strategy in this situation would be to sell out of the money puts and buy calls on gold to take advantage of the negative skew. If this strategy confuses you, make sure to learn how to trade options efficiently. […]

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