# Learning to trade option strategies : Call spreads as volatility trades

In this series we will go through some option strategies in detail and discuss how we learn to trade, and importantly manage the risk associated with, different option strategies as volatility plays. We will be using screenshots from a Volcube game to illustrate the points made.

You may wish to print out the screenshot above that shows the trade we are going to analyse.

The trade we have executed in this Volcube game is the 100 / 109 call spread. We have sold 250 lots of the call spread, un-hedged, at a price of 2.59. This means we have sold 250 lots of the 100 calls and bought 250 lots of the 109 calls. You can see this in the bottom left pane which shows our Inventory. You will see the 100 calls have a red 250 (indicating a negative number and therefore a short position) and the 109 calls have a green 250 (indicating a long position in that strike). You can also see the trade in the Trade Log, which is the pane in the top left of the view. This shows the two ‘legs’ of the call spread. For your guide, the other panes are the Pricing Sheet (which shows the theoretical value of all the options that are listed), the Risk Detail (which shows our Greeks), the Risk Limits (which shows how our risk is viewed by the Volcube Risk Manager) and the Messenger which is where we interact with the broker in the game.

The Pricing Sheet shows us the theoretical value of options given by our pricing model. We can see that the 100 calls have a theoretical value of 3.154 and that the 109 calls have a value of 0.601. This means the call spread has a theoretical value of 2.55, given the current spot price and current theoretical levels of implied volatility. So by selling the call spread at 2.59, we hope to have captured 4 cents of ‘edge’ or profit. We hope we have sold the call spread for more than it is, theoretically, worth. Our risk is that the value of the call spread alters. If for example, the value of the call spread increases to 2.60, then our 4 cents profit has vanished and we have in fact made a loss of 1 cent. So for the professional option trader it is a case of managing the position to minimise the likelihood of the 4 cents being lost *until* the trader is able to liquidate the position.

Let’s analyse some of the most important risk factors that could cause the portfolio’s value to change. All of these factors represent a risk to our theoretical profit.

The most pressing risk is that the price of the Spot product will change. This has a direct impact on the call spread’s valuation via the delta. Specifically, if the spot product price falls, the call spread will decline in value and if the spot price rallies, the call spread will appreciate in value. So we have a direct exposure to the price of the spot product. Fortunately this is easy to hedge; we just need to trade the underlying in the appropriate size and direction. Here we need to **buy** some deltas (i.e. buy the spot product) because we are short the call spread and therefore short delta. The amount of spot we need to buy is dictated by the delta of the strategy, the quantity of the strategy in our position and the multiplier of the options. You can in fact watch a brief video about delta hedging in Volcube here. In the case of our call spread, we need to buy roughly 9140 lots of the underlying to delta hedge. You should be able to see this in the Risk Detail matrix in the Delta row in the column headed by ‘100’. This shows the position delta with the spot trading at 100. If you want to actually calculate the appropriate delta hedge, you work out the delta of the call spread (which is the delta of the 100 calls = 51.6% [see the Pricing Sheet ‘Delta’ column for that] minus the delta of the 109 calls = 15%, which gives 36.6% in total). You then muliply by the number of call spreads (250) and then by the contract multiplier (i.e. the number of lots of the underlying that each option entitiles you to trade, which in Volcube is set at 100). 36.6% * 250 * 100 = 9150, the slight discrepancy reflecting the rounding of the deltas.

So to eliminate the delta risk associated with this call spread, we need to buy roughly 9150 lots of the underlying. This is the most pressing risk we face because the spot product price is more volatilite than the other risk factors that can affect the call spread. The following image shows the position *after *the delta hedge has been exectued. Notice how the delta risk in the Risk Detail versus the 100 spot price has now dropped to zero. Notice too how the Theo P&L slide along the bottom row has changed. We are no longer asymmetrically exposed to large moves in the underlying product price. We do still have exposure (in so far as our p&l does change when the spot moves, i.e. looking left and right along the slide), but it is no longer as simple as ‘make lots of money if spot falls/lose lots of money if spot rises’.

In the next articles in this series (coming soon) we will consider some of the other risk factors (vega, gamma, theta, alpha and ddelv) and how they can be managed in Volcube simulations (which of course reflects how they are also managed in real option trading).

If you would like to practise trading and risk managing call spreads, why not start a FREE 7 day trial of Volcube?

## About Volcube

Volcube is the world’s leading options education technology, trusted by traders and other individuals everywhere as the fastest way to learn about options trading.

### FREE TRIALS of Volcube Starter Edition : start your options education for FREE!

You can access Volcube Starter Edition for FREE. Starter Edition has been designed specifically for individuals who want to learn about options trading from home or at work. If you want to learn about options trading, try Volcube out for free today! Click here to get start your completely FREE trial.

### : Volcube : Options Education Technology :

:

## Volcube : options education technology

- *
**Start your FREE Volcube trial.** - * Login to Volcube via your web browser.
- * Trade on the options market simulator.
- * Learn from the options trading videos.
- * Test your trading ability with Volcube trader metrics.
- * Become a Certified
*Options and Volatility Trader*