From the May 01, 2007 issue of Futures Magazine • Subscribe!

Question: What strategy can offset the added risk in a position during a period of high volatility?

It is a particularly good time to look at strategies to offset volatility risk because implied volatility in equity markets has recently spiked. With an increase in volatility, the price of all options, both puts and calls, increases. The option price rises due to an increase of the option’s extrinsic value. Extrinsic value is the part of the option’s price that is above intrinsic value. The extrinsic value will increase by the amount of the option’s vega or volatility sensitivity. If the option has a 6¢ vega, then the extrinsic value of the option will increase by 6¢ for every 1% increase in volatility.

The more the option’s extrinsic value increases, the more the stock must outperform to offset the additional expense of the option due to the higher volatility level. In a nutshell, the option has become “expensive” so the simple purchase of the option has now become more risky. On top of that, the option can actually lose value if the volatility level comes back down to normal or if it decreases. This makes it dicey at best to be a straight option buyer.

There is a way of limiting this volatility risk. You can choose an option that is deep in-the-money where vega is smaller. But even these options start becoming very expensive due to the option’s drastically increasing intrinsic value.

This leaves us with a dilemma. Do we take a chance and buy an option loaded with extrinsic value at risk of decreasing volatility, not to mention time decay, or do we put out additional capital and spend more than we want to for a deep in-the-money option? This is a decision that does not have to be made, because there is another, better alternative: the vertical spread.

The vertical spread is an option strategy where one call/put is bought and another call/put in the same month and a different strike is sold in a one-to-one ratio. The vertical spread is a cost efficient way to play directional stock movements, especially in the case of a high volatility scenario. Besides cost efficiency, there is a twofold reason that the vertical spread is the optimal strategy to use in high volatility situations.

First, the purchase of one option and the sale of the other help to minimize the vega of the spread. Remember, vega measures the option’s sensitivity to movements in implied volatility. You become long vega when you buy an option and short vega when you sell an option. So, if you are long vega and volatility increases, then the value of the option will increase. If volatility decreases, then the price of the option will decrease.

The second reason to use the vertical spread in a high volatility situation is the little known concept of trumpification. Trumpification is a delta effect caused by increased volatility and/or time. It causes in-the-money options to lose delta and out-of-the-money options to gain delta. All options in a rising volatility environment move towards a 50 delta. To see this effect yourself, go to your option trading platform and go to the page that shows the “Greeks.” Observe your deltas in a given month and record them. Then, for the same options, record the theoretical values. Now that you have recorded the deltas and theoretic values, adjust volatility higher, much higher, to better see the effect. You will be able to observe the “crunch” (trumpification) of the deltas, but more important, the “crunch” of the prices. This crunch is the tightening of the values of the options. It is closing the spread between the different option values. It is making the value of the vertical spreads cheaper.

The mechanics of vertical spreads is that debit spreads need to expand for you to profit while credit spreads need to contract for you to profit. This can happen naturally by a movement in the stock in the direction of your lean. But this can also happen by volatility decreasing and/or time passing. So, even if the stock does not move, you can make money with just a decrease in volatility or the passage of time. In the case of high volatility, the vertical spread gives you several ways to win.

There is a lot more to learn and understand about the vertical spread than can be covered here. It is extremely flexible, versatile and cost efficient. The vertical spread has many uses but none any more important than giving the investor a great “option” when looking for a way to offset or neutralize a high volatility situation.

Ron Ianieri is co-founder and chief options strategist at OptionsUniversity.com and a 10-year veteran on the floor of the Philadelphia Options Exchange.

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