You usually set up a bullish buy spread when you have a positive view on the underlying. But can you combine your directional view with a volatility view? This week we discuss the difference in trade setups between European and US options when you combine your view of the underlying with that of volatility.

Capture Vega

When you have a volatility view, you are betting that implied volatility is likely to explode (rise) or implode (fall). Suppose the implied volatility of an underlying was 20% in the recent past and the current implied volatility is 12%. Further, assume that an event is likely to occur in the future whose outcome is unknown. You expect implied volatility to explode during this period. You also think the underlying is likely to rise and face resistance at a higher price. What should you do?

You can set up a bullish call spread where the lower strike call is either an at-the-money call (ATM) or an immediate out-of-the-money call (OTM). Your choice of strike price will be based on the liquidity rule; choose a strike that has the greatest change in open interest. The short call will strike immediately above the underlying’s resistance level. But when you have a view on volatility, your setup needs to be aligned to capture vega gains.

The sensitivity of an option’s price to changes in volatility is captured by the Greek vega option. An ATM option has the highest vega. This means that the price of an ATM option will change the most for a one percentage point change in volatility. Also, the price of an option goes up when volatility explodes and the price of an option goes down when volatility implodes. Combining these two arguments, you should consider taking an ATM option when you expect volatility to explode and consider selling an ATM option when you expect volatility to implode.

Now consider the first scenario – the underlying rises and volatility explodes. If you are long on an ATM option, you can sell an OTM option that is one move above the resistance level. So, this strategy is the same as the regular bullish call spread when you don’t have an explicit view of volatility.

Consider the second scenario – the underlying rises and volatility implodes. Now you need to short the ATM option. In a bullish call spread, the short strike is the highest strike. Therefore, the lower strike price must be an in-the-money call (ITM). But this poses a problem. The maximum gain in a bullish call spread is the difference between the strikes minus the net debit. Therefore, the position – long ITM call and short ATM call – will not allow you to capture maximum potential gains, as the resistance level of the underlying will be above the ATM strike.

Also, ITM strikes are not liquid for European options. Therefore, you are forced to choose between ATM and OTM strikes. Your optimal strategy for the second scenario would be: an immediate OTM long strike and short above the resistance level, which is no different than a regular bullish call spread.

Optional reading

If you were to trade US options, you could buy a deep ITM call for the second scenario described above. Even if the strike price has not been traded, you can exercise the option when the underlying reaches your target price before expiration. Note that you can only capture intrinsic value when exercising an option. Additionally, when volatility implodes, the time value of an ATM option will decline more than that of an ITM option.

The result ? Combining your view of the direction on an underlying with a bet on volatility puts the ATM option in the center. But adjusting a bullish call spread for an implosion in volatility could be a problem for European options.

(The author offers training programs for individuals to manage their personal investments)

Published on

August 27, 2022