Just as a risk reversal takes advantage of skew to get bullish exposure to the underlying stock, vertical spreads can take advantage of skew, and some of the other phenomena we’ve discussed, to get bearish exposure to the underlying.
A vertical spread is executed when you buy one option and sell another option of the same type (put or call) and the same expiration date but with a different strike price.
While vertical spreads, sometimes simply called verticals, can be either bearish or bullish, skew is generally working against a bullish vertical spread, whether it’s a call spread or a put spread, so we’ll focus on bearish vertical spreads.
Since we’re focusing on bearish vertical spreads in order to take advantage of skew we’ll look at buying a put spread (buying the strike price that is closer to at-the-money and selling the strike price that is further from at-the-money) and at selling a call spread (selling the strike price that is closer to at-the-money and buying the strike price that is further from at-the-money). Table 14.1 shows two bearish vertical spread examples for IBM stock.
|Put Spread||Option Price|
|Buy July 200 Put Option||4.30|
|Sell July 180 Put Option||1.00|
|Net Premium Paid||3.30|
|Sell July 210 Call Option||4.80|
|Buy July 230 Call Option||0.50|
|Net Premium Received||4.30|
In buying the July 180/200 put spread our trader would buy the July ...