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How to Use Vertical Option Spreads
09/29/2009 12:01 am EST
Verticals and Volatility
Every once in a while, students ask me if it is wise to sell verticals on any given product at any time. The answer is much more complex than a simple yes or no reply. In this article, I will explain my thinking when it comes to selling verticals, either bull puts or bear calls. For a change, I will not focus on the technicals or fundamentals, but instead, I will place my entire center of attention on the I.V. (implied volatility) of the underlying and three additional option components.
In order to present my point clearly, I have selected three different products that are sitting at different volatility levels. The first one is sitting at its 52-week I.V. low; the second one is at its 52-week I.V. high; and the third one is somewhere in between. Figure 1 below presents all the essential facts of all three underlying in a table format.
Let me explain what those I.V. readings actually mean for each one of the products. SPY's I.V.—at the time of writing this article—was 21.06 % (I.V. is always expressed in percentage form), while SPY's 52-week low was 20.51% just a couple of trading sessions ago. When the current I.V. is compared to its 52-week high, it could be easily observed that the volatility has come down significantly. If the I.V. is low, then the option premium tends to be fairly priced. The next figure shows the option chain for SPY.
In Figure 2 above, one can observe that the spread between the bid and ask is very thin, which means two things: The product is extremely liquid and also popular. Observe the size of open interest (O.I.) and volume on any of the strike prices of SPY—they all show huge option trading interest in them.
Next, let me answer the question of whether SPY should be a candidate for selling a vertical spread. My rule of thumb is the following: Be a net premium seller when the I.V. is high, and in the case of SPY, the very opposite is true.
By contrast, my second example is nothing like SPY. I have selected a stock from the health care sector: BioMimetic Therapeutics Inc. BMTI's current I.V. is 156.47% and its 52-week high is the same, 156.47%.
Again, let me address the question of whether BMTI is a great candidate for vertical spread selling. At first it appears so, for the I.V. is high, but should the option trader just sell blindly without checking anything else about the underlying? Of course not.
Prior to making any rush conclusions, it is good to go over the fact that just because the stock is optionable, it does not mean that options should be traded on it by option speculators. In many of my previous articles, I have clearly stated that I always look for three things: (1) A tight bid and ask spread, (2) High O.I., and 3) Huge volume on the individual strike prices.
A glance at Figure 3, which shows the BMTI option chain, could give the speculative option trader a clear clue to stay away from trading options on BMTI. Hence, just because BMTI has high I.V., it does not mean that one should get in to it by selling verticals on it. There is more to being a vertical credit spread trader than just looking for high I.V.
Lastly, UNG (the ETF that tracks the performance of the United States natural gas futures contracts) has I.V. somewhere in between its extreme low and high. To be specific, it isn't exactly at its 52-week high of 86.57%, but it is in its higher range, namely 77.60%. This meets my criteria for selling verticals, so the next step for me is to look at the three components mentioned above. Figure 4 presents the UNG option chain.
Let me go through each of these three components. The bid and ask spread is not as thin on UNG as it is on SPY, yet that isn't a disqualifying factor for me. Both the O.I. of UNG and the volume on the individual strike prices are decent, therefore, that is another green light for me.
In other words, I myself would consider UNG to be a good candidate for selling a vertical spread. However, the question remains to which direction, and I will not answer that question, for this is not a trade advisory. It is for educational purposes only.
In conclusion, if I would call I.V. the tip of the iceberg or the surface, then I should also call my three option components (bid and ask spread, O.I., and volume), checking what is below the surface. In other words, if I go back to the original question (Is it wise to sell verticals on any given product?), my answer is:
Check both the surface (I.V.) and below the surface (my 3 components) prior to doing any net premium selling. Be well informed about your product from multiple levels prior to opening a position on it and have green trading.
By Josip Causic of OnlineTradingAcademy.com
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