Using Spreads to Offset Risk

As a general principle, when the market and stocks move lower, implied volatility (IV) rises. When the market and stocks trend sideways or move higher, IV generally falls or stays where it is. High IV means option prices increase and when IV falls, they typically get cheaper all things being held constant. Option traders try to sell when IV is high and buy when IV is lower. Sometimes, of course, that is not possible.

Over the past couple of weeks, the market has been volatile with many stocks falling from recent highs. IV level has certainly spiked to levels not seen in quite some time. This means option prices also spiked. Let’s take a look at the chart below.

The stock dropped from recent highs and IV surged as noted from the 30-day IV (red line). If an option trader was expecting a move higher after the recent drop, a long call would be an option as a bullish position. A long call also has positive option vega. In simple terms, a 1% change in IV will increase or decrease the option premium. Since a move higher is expected, IV will generally decrease if that happens. Vega will lower the premium if that happens. What can an option trader do?

If an option trader adds a short call to the position with the same expiration (see chart below) to create a vertical debit spread, positive vega is offset with some negative vega from the short call.

In fact, all the greeks (delta, gamma, theta and vega) will have positive and negative components. As I like to say, everything in option trading is a tradeoff, including choosing a spread trade like the one above.

You don’t have to be an option’s greek guru to truly understand how options work, but it can help. Just knowing how to offset some risk (in this case vega) can improve your trading considerably.

John Kmiecik, Market Taker Mentoring

Trader Education