Vertical Spreads - Market Analysis for Nov 28th, 2016

Introduction
There are many ways to create trades that have a directional component built into them (profit for a move of the underlying in a given direction). The simplest trade is to use the Optimizer and find the right call or put to play the move. It is a very simple kind of trade with lots of advantages including limited downside risk and unlimited profit potential plus the gamma acceleration of the options. Some people prefer to use vertical spreads to create directional trades, however because of the nature of the position, it has both limited downside risk and limited profit. Given that why would anyone use a vertical spread at all over just outright options?

Advantages of spreads

Well, spreads do have advantages but all of them come at the cost of sacrificing unlimited profit. So as you can see there is no such thing as a free lunch. The list of advantages is long but here I will highlight a few:

Spreads can be used to enter a directional position at a cheaper price (as the short leg of the spread is financing the long leg).
Very tight spreads can be used to protected about excessive vega in a positions, in other words to protect against big changes in implied volatility.
Very tight spreads can also be used to profit from variations in the skew of the volatility smile of the underlying.
In general spreads have multiple modes for almost all greeks. In other words, delta, gamma, and vega can flip sign at certain levels so an spread can be used to take advantage of that fact. For instance starting long gamma, but then flipping short after some time (or vice versa).

As you can see the fact that spreads can profit from a directional move is almost secondary. The main advantages of spreads reside in the advanced features like gamma/vega flipping. However there is nothing wrong with using them just for a directional purpose.

Type of spreads

I know that the internet and the literature list all possible combinations of the spreads, but in real life there is only two main type of spreads: Bullish and Bearish. That is it, there is no need to complicate your life. The confusion arises because many people think that there are  differences between spreads with calls, or with puts, or if you enter with a debit, or receive a credit. However because of the Put/Call parity feature of vanilla options, it really doesn’t matter what you use, at the end your spread will be either Bullish or Bearish. It doesn’t matter if you use calls or puts, debit or credit a Bullish spread behaves exactly the same! The same applies for a Bearish vertical spread, it behaves exactly the same independent of what you use to create it.

Now, there are minuscule differences due to market structure (for instance calls can be easier to trade for some underlyings while for other puts are easier). Or some options have better bid/ask spreads but in general due to Put/Call parity the differences are very small. Some people prefer to receive credit for the spread, others prefer not to use margin and pay debit. Very small differences that don’t change the fact that the spreads will behave exactly the same.

Designing a vertical spread Trade

Because there are only two types of spreads, then your first decision is to choose if you want a Bullish vertical spread or a Bearish vertical spread, once that is done is when the fun begins. Picking the right strike combination and expiration depends on the goals of your trade.

Once the direction is chosen, we have to decide if we want the spread to be long gamma or short gamma at inception. This choice is very important and it can expressed in terms of a different parameter for those of you that are not used to the concept of gamma. In other terms, a long gamma position suffers from time decay at inception (it starts losing money right away from the moment the position is entered and as time passes), in exchange for that time decay, the position will rapidly gain money if the underlying moves in your direction. Conversely if a short gamma position is chosen then time is in your favor and the position will make money since the moment is opened and as time passes. However by monetizing that time decay you are giving up upside potential, the position will make some money when the underlying moves in your direction but it will lose money rapidly if it moves against you.

Another way of seeing this, is that a long gamma vertical spread is very similar to a long option position, with the difference being that the profits are capped. While a short gamma vertical spread is basically a neutral long/short position that makes money if the underlying doesn’t move or if it moves in your direction.

So as you can see you need to decide if you want a mostly directional play, or a neutral/directional play first. In the second part of this post we will see more design parameters and also how to express the whole thing with a practical example.