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

Using a vertical options spread to greatly reduce vega risk

Option Strategy

A vertical spread is the simultaneous purchase of one put (or call) and the sale of a further out-of-the-money put (or call). The most that can be made on the vertical spread is the difference between the strike prices minus the cost of the spread.

The 1120 (long put) - 1070 (short put) vertical spread would cost $17.85 ($37.45 – $19.60). This would give us a profit potential of $32.15 (distance between strikes – cost of spread) if the SPX index drops 5%, a 180% return for the same move.

Because we are long one 1120 put with a vega of $0.96 and short the 1070 put with a vega of 0.82, this spread has a net volatility exposure of 0.14 vega ($0.96 – $0.82). With the same drop in volatility as above, the spread would lose only $0.84 per spread as opposed to $5.70 with the naked put (see "A safer short").

The vertical put spread performs better with more protection and less cost than the naked long put, while at the same time it has much less risk exposure — $14 per spread per point (instead of $96 per naked option) — should volatility drop.

Vertical spreads are the building blocks of more complex options strategies. Once you learn the vertical spread, you can construct more dynamic positions that can be sustained in volatile market conditions without being exposed to large losses.

M. Burkhardt is the CEO of option education firm RandomWalk Trading. Additional educational material is available at randomwalktrading.com.

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