Call spreads and put spreads: option trading essentials
Buying a call spread involves buying a call of one strike and selling a second call of a higher strike. Buying a put spread involves buying a put of one strike and selling a put of a lower strike. Remember that if you need reminding of this during a single player Volcube trading session, just click on the Market Mentor icon when you are faced with a quote or an order in a call or put spread.
If you look at the Volcube (or any other) pricing sheet you can get a feel for the characteristics of different call and put spreads. One essential point to note is that the closer together the strikes of the options in the spread, the lower the total vega of the spread. The vega of the spread remember is simply the difference between the vega of the two options. As the closer two options are strike-wise, the more similar they will be in general, it stands to reason that the closer the strikes of the spread, the lower the risk will be, since the off-setting effect from buying one option and selling the other (ie trading the spread) will be greater.
Running a Volcube option market simulation on the default setting, we can see for example that the 100 calls have a vega of 12.6 and the 104 calls, a vega of 11.4. So the 100/104 call spread has a vega of just 1.2, which is approximately only 1/10th of the vega of the 100 calls alone. Therefore, in vega terms, trading the 100 calls is 10 times more risky than trading the 100/104 call spread. This suggests a couple of things. Firstly, when you respond to a quote in the 100/104 call spread in Volcube, you really should be looking to make the width of your price (the difference between your bid and your ask) a lot narrower than you would for the outright 100 calls alone. Secondly, the quantities we attach to our quotes should be larger, other things being equal, in the call spread than in the outright alone, because the vega risks (and other risks too) are so greatly diminished. This is a simple way to improve your option trading and your scores on Volcube; look to adjust your prices and quantities appropriately for the risk that the strategy entails.
We can also see in the pricing sheet that call and put spreads can have skew implications. For example consider the 100/90 put spread. The 100 puts are at-the-money options and are unaffected by skew movements. Whereas the 90 puts have a 9% delta and less than half the vega of the 100 puts. Puts such as these typically can be greatly affected by changes in skew. Let’s assume the spread has a theoretical value of 2.81 and that we pay 2.79. This makes a 2 tick theoretical profit. Now with this spread we are not just exposed to changes in the overall level of implied volatility in the market, but also have skew risk. If the general level of implied volatility stays constant, but the put skew increases, then the put spread’s value must fall (due to the rising price of the 90 puts). So when we trade the 100/90 put spread we have an extra exposure, namely skew risk.
Using Volcube to learn how to trade call and put spreads
Try trading through a session with only outrights, call spreads and put spreads selected. Try trading different spreads just to see how they affect your risk. With each spread that is quoted, ask yourself whether the risk is relatively high or low and whether the spread entails any skew risk? Practise this over and over until you are able to characterise any call or put spread rapidly and make an accurate and timely price to the Volcube broker in appropriate quantities.
Another tip for as your positions become complex is to consider whether say a particular put spread is likely to help or hinder your overall risk situation? Remember to make the most of the in-game Market Mentor advice to get real-time intelligent help when learning how to trade call and put spreads.
Finally, try trading a wide spread such as the 100/90 put spread and watching how its value and profile alters as the skew changes in the market during your trading session. This can be a great way to learn how such spreads are affected by both changes in implied volatility and changes in skew.
Learning to trade derivatives? To try Volcube for free, go to www.volcube.com/products.