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Will you get a bigger credit for an OTM call or put credit spread in SPX?
I asked this question today in a teaching session at Sheridan Mentoring.
Most thought the answer was puts because OTM puts are always higher implied volatility than OTM calls, which is true. But, the answer was that you get bigger credits for OTM call spreads than put spreads in SPX.
Let’s look at an example. SPX is currently around $2121. On the call side, I sell the 2185-2175 June credit spread for $1.62 credit. The delta of the short call is 15. On the put side, the 2010-2020 put credit spread is around $1.10.
The delta of the short put is 15 also. Why did the call credit spread get more credit when the short delta of the call and put spread were both the same at 15? Couple things going on here.
First, the implied volatility of the put your buying on the put credit spread is always higher than the implied volatility of the put you are selling.
Call Credit Spread
Versus the call credit spread, the call you are buying is usually lower implied volatility level than the call you are selling, that makes a difference.
Second, notice that though we are selling the same delta for the short call and put, the short put is 100 points out of the money while the call is only about 54 points out of the money. Most stocks don’t have the same volatility structure in out of the money options as do SPX and RUT.
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Dan Sheridan has seen the Options Business from both the institutional and retail side with 24 years as a Chicago Board Options Exchange market maker and another 10 years as an options mentor for private traders. His approach, however, has remained consistent: To be successful, you must treat options as a business.
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A very popular method of managing options trades, particularly complex ones, is to use the Greeks…
The “Greeks” that we use are Delta, Gamma, Theta and Vega.
- Delta tells us the rate of change and the profit and loss of our position for the next point move in our underlying. It gives us a number that tells us what that change will be.
- Gamma tells us how much the Delta will change after one point and can also be beneficial in letting us know how fast things may be moving for or against us.
- Theta, which is popular in the Sheridan Community [theta positive], shows the effect of time in either benefiting or detracting from your option position Profit/Loss.
- Vega monitors the volatility of our position and the effects that implied volatility changes will have on our position. It also is a number that tells us how much profit or loss our position will have with a one point move in the implied volatility of the options that we are trading.
There is more to trading and managing options than just using the Greeks. Many times I’ve seen traders who thought they could look at the Greeks alone and manage a position, which often leads to problems.
Using the Greeks
Certainly, we would use the Greeks, but you also would want to have a risk graph to monitor your P&L position and the effects of where you are if the trade goes against you.
This concept is very important to understand because, if for instance, we were going for a 10% profit, you really would not want your position to go against you more than 6-7% before you made an adjustment.
Greeks are Vital
As you can see, the Greeks are vital, because we can use them to tell 1) where we are at in a position and 2) where we are going to be in a position.
Further, the Greeks can also be helpful if you do want to adjust the position. One popular technique is to just cut the Delta of your position.
For instance, if your Delta was -1000, you know that if the underlying went up one point you would lose a thousand dollars, so in this instance, you may want to cut that risk down by buying extra options.
Cut the Loss
This move would cut the loss, perhaps, to where you only lose $250 with the next point, thereby cutting by 75% you risk. This is just one of many possible moves to make in this scenario.
Just remember to incorporate Greeks, P&L and a risk graph into your position management and do not rely on any one component to make all of your trading decisions.
Mark Fenton, Senior Options Mentor