From the November 01, 2011 issue of Futures Magazine • Subscribe!

Using a vertical options spread to greatly reduce vega risk

Option Strategy

Question: How can you execute a bearish opinion with options when volatility is dangerously high?

Answer: Execute a vertical spread that greatly reduces vega risk.

Markets in general and equity markets in particular have been jittery. Foreign and domestic economic uncertainties have led to huge whipsaws in many asset classes. While this would appear to be an ideal time to short stocks or purchase a put and go for a ride on the south-bound train, even the long put, with its finite exposure to a bear market rally, has additional risk in this environment.

The problem with the long put scenario is that volatility is trading at greater than 40%. With volatility that high, any bounce in the markets will result in a collapse in implied volatility of the options. Because we are considering the purchase of a put, a market rally accompanied by a drop in the implied volatility levels would be a "double whammy" for our position.

Remember the Greeks. The option’s delta and vega (volatility) will have the biggest impact on a long put position should the market bounce. One way of minimizing the voracious appetite a naked long put has for your precious capital is to spread much of the risk by using vertical spreads. A long vertical put spread will reduce the exposure you have against a rally, but more importantly, it also greatly will reduce the exposure you have to vega, the effect of volatility on the price of your option.

On Oct. 4, volatility in the S&P 500 options fell more than six points to close at 40.84% after a 24.72-point rally in the SPX. If you were naked long an S&P put, you would have lost $5.70 on the price of the put from volatility alone. A good vertical spread dramatically could have reduced the loss from the volatility collapse.

If you thought at the beginning of the month that the S&Ps were due to drop another 5% in October, buying puts would be a solid low-risk play. Below is the price chain for October options with three weeks to expiration.

If the S&Ps were to fall 5%, the SPX index would go from 1123.95 to 1067.75, a 56.20-point drop. This means that if you buy the 1120 put for $37.45, it will have $52.25 of intrinsic value at expiration (1120 put – $1,067.75).

With an intrinsic value of $52.25, you will have made a $14.80 profit on your investment ($52.25 intrinsic value – $37.45), or a 39.5% return. Keep in mind that you also were risking $37.45 and the 1120 put has a vega of $0.96. If volatility drops six points, that option will lose $5.70 ($0.96 X 6 volatility points).

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