Since Implied Volatility (IV) has been frustratingly low we have been looking at strategies that are not Delta Neutral such as our go to short Strangles and to more directionally based strategies like Vertical Spreads. Our Probability Of Profit (POP) on a vertical is known at order entry. It is determined by how we set up our strikes and whether we use a debit spread or a credit spread. When should we choose a debit spread and when a credit spread and once we choose how do we set them up?
When Implied Volatility Rank (IVR) and IV are high we will choose the credit spread. The spread should consist of a short out-of-the-money (OTM) Call (or Put) and a long Call (or Put) that is even farther OTM. Our goal is to select strikes so that the credit we receive is at least ⅓ of the width of the spread. A table showed that the farther OTM is our short strike the higher is our POP but the trade-off is a smaller credit. Tom noted, “you need to have enough credit to justify the risk.”
When IV is low, such as now, we will look to use a debit spread. We generally prefer to be short premium because that allows us to take advantage of Theta (time decay). By structuring our debit spread properly we can also take advantage of Theta. Our debit spread will consist of a long in-the-money (ITM) option and a short OTM option in which the intrinsic value of the long option is greater than the overall debit. Additionally, this means we can be somewhat directionally wrong before we see the breakeven price. Our debit spreads will have a lower POP than our credit spreads, but by taking advantage of Theta we can turn the odds in our favor.
For more information on Vertical Spreads see:
From Theory To Practice from February 16, 2016: "Vertical Credit Spreads"
Options Jive from April 5, 2016: "Vertical Spreads | Which Strikes Should I Use?"
Options Jive from June 16, 2016: "Credit & Strikes for Spreads: Why 1/3 of Width Works"
Watch this segment of Best Practices with Tom Sosnoff and Tony Battista for the valuable takeaways and a better understanding of when we choose a vertical debit or credit spread and how to properly structure them.
This video and its content are provided solely by tastylive, Inc. (“tastylive”) and are for informational and educational purposes only. tastylive was previously known as tastytrade, Inc. (“tastytrade”). This video and its content were created prior to the legal name change of tastylive. As a result, this video may reference tastytrade, its prior legal name.