Limiting Risk and Margin with Vertical Credit Spreads is an alternative to other more risky strategies, such as naked options. These spreads, like many strategies – can be used in harmony with seasonal trends of commodities, provided the market’s fundamentals support the trade(s). The Advantages are:
- Lower Risk
- Lower Initial Margin requirements
- Limited possible Drawdowns
- Less Price Volatility During the Trade
- Some insulation from IV% changes (IV% = implied volatility)
The Disadvantages (versus naked options):
- Lower Return On Investment (ROI)
- Lower Delta (Less sensitive to moves in the underlying’s price)
- Slower Net Time-Decay (being long one and short the other option slows down the rate of time-decay (theta.)
In the two examples below, options on corn futures are used. Prices for corn futures are quoted as cents-per bushel: For example 357 is equal to US$3.57 dollars per bushel. Since each contract represents 5,000 bushels, one cent = $50 (5,000 x 0.01) Example: An option price of 5.50 means 5.5 cents times $50 per cent = $275
Vertical BEAR Credit Spread Using CALL Options:
The “Vertical” means using options in the same CLASS (same expiration date)
Market bias of the trader for the underlying’s price is neutral-to-bearish.
This strategy SELLS one CALL, then BUYS one CALL at a HIGHER STRIKE, resulting in a net credit into the trading account.
Vertical BULL Credit Spread Using PUT Options:
The “Vertical” means using options in the same CLASS
Market bias of the trader for the underlying’s price is neutral-to-bullish.
This strategy SELLS one PUT, then BUYS one PUT at a LOWER STRIKE, resulting in a net credit into the trading account.
Vertical Credit Spreads Discussion:
Combinations with options that result in a CREDIT to the trader’s account are called credit spreads. Combinations with options that result in a charge, a debit, are called debit spreads.
Vertical credit spreads are long one option and short another in the same option class that results in a net credit to the trader’s account. Since the trader is simultaneously long one option and short another, this somewhat dampens the effects of changing IV% (Implied Volatility) during the trade. Being long one option and short the other has a canceling effect that reduces changes in implied volatility and this also slows down the time-decay rate of the trade (the theta.)
Since the net delta of an option combination trade is the algebraic sum of the deltas, the long option’s delta is positive and the short option’s delta is negative. The means as one of the options loses value, the other will gain value; this results in the net value of the combination changing at a slower rate than a single-option trade. Simply said: This means the value of the trade will move slower per move of price in the underlying -than a single option would. Another way to say this is: The single option trade will make or lose money faster than a vertical spread and the single option trade has a faster time-decay rate.
To eliminate confusion: Let me say that this discussion of vertical spreads is about 1:1 ratio spreads, not other ratio combinations. A trader that chooses to use a vertical credit spread chooses it because it is less risky, the main trade-off being that there is less profit (ROI.) The pros and cons are listed at the top of this article.
Even though a vertical credit spread’s value changes slower than a naked option (the spreads have a lower delta and less risk), the vertical spread is a safer strategy and has a limited maximum drawdown value which is known when the trade is placed. I am saying the maximum possible loss of the vertical credit spread is both limited and known at the time (before) the trade is placed. While a naked option has a theoretically unlimited loss potential – it has a higher potential ROI than the spread and a much faster time-decay rate (theta.)
Vertical Spreads are a great tool that belong in every option-trader’s toolbox. The distance between the two option’s strikes will determine the maximum risk and define the potential profit of the trade. This article is about credit spreads for option sellers to profit from either a bullish or bearish market price bias inside of a defined time period, as defined by the options expiration date. – Don
If you are new to options and/or need to refresh & review your knowledge of strategies and terms, please consider my playbook on the most popular option strategies (this book uses stock option examples but the principles are the same as in commodity trading.) It has over 30 simple diagrams of strategies like the ones used in this article. read more…. Thank you – Don