Equity and Index Options Explained

18

Long Verticals versus Short Verticals

We have already seen the way in which call and put spreads may be used to exploit a directional view on the underlying. For example, buying call spreads may be used to exploit a bullish view on the underlying. An alternative trade would be to sell put spreads, a trade that also exploits a bullish (or at least not bearish) view on the underlying. So which should we choose? If we are bullish on the underlying, should we buy call spreads or sell put spreads?

Broadly speaking, the answer depends upon our exact view on the underlying. Specifically, if we are positively bullish, then buying call spreads seems logical. If, rather than being positively bullish, we are simply not bearish, then selling put spreads seems logical. So far so good. But our choice of trade will also depend upon whether we want the “odds” (risk/reward) in our favour or the “odds” against us. Remember, vertical spreads may be viewed as fixed odds “bets”, directional trades where the extremes of both risk and reward are known. Do we want the odds of the “bet” in our favour or the odds of the “bet” against us? Instinctively, the majority of traders would prefer the former, to have the odds in their favour but, as ever in the markets, there is a price to pay for this. That price is time decay. In practice, most call and put spreads that are traded are out-of-the-money. Out-of-the-money call and put spreads have negative theta, they erode due to the passing of time. So, if we ...