Monday, March 15, 2010

Basic Spreads – Part 3

Now that we have taken a look at some generalized expectations for implied volatility over time, we can reexamine how that impacts the buying of basic spreads. In both cases, we were purchasing the near-the-money option and selling the next strike up or down.

The first thing that is likely to come to mind is that when you buy a put spread you are capitalizing on the implied vol skew by purchasing the lower implied vol options and selling the higher. Hopefully, this will help reduce the cost of the hedge or bearish bet. In the CGX spread which was hypothetically initiated on March 5, with 43 days to April expiration, there was a theoretical skew in implied volatility between the 40 and 45 strikes. Unfortunately due to the wide markets, most of that was sacrificed in the bid/ask spread and this is not an uncommon occurrence in less liquid options. In other words from the perspective of the initiator, the skew is difficult to capture but still allows for some improvement in net outlay. The stock has been as high as $48.48, since the trade and today hit a low of $44.55 with implied vol holding fairly steady in the mid 40s. If the stock had held near its recent high then IV would likely be diminished exacerbating the losses accruing as a result of adverse price action and time decay. In other words, the probable downside parallel shift across IV in the April strikes is an additional negative factor to the position. Should price action be favorable (the stock declines), if it is not rapid enough, then it is possible for potential gains to be offset by time and a potential decline in implied vol. However, if it is quick, then the position has the potential to benefit from an increase in IV as well as the favorable price action.

Compare this to the hypothetical call spread purchased in CMI. Given the same expectations regarding the skew of the strikes in April (IV decreases as strike price increases), not only do you end up selling an option with a lower implied volatility than the one purchased, but IV may work against you even if the price heads higher. Barring takeover speculation, a stock that moves higher is more likely to see declining IV levels. When you combine this with the adverse effects of the passage of time, it is possible that you could be breaking even or making a small loss even if you are right directionally. On the other hand, an increase in IV levels that is probable with a quick decline in a stock's price is unlikely to offset losses associated with the adverse price action.

In sum, favorable price action is likely to favorably impact a long put spread in terms of implied volatility, but act as a small detriment to a long call spread position. In both cases, as with any long option position, time will be working against you both in terms of decay and as skew becomes a smile. Once again, I feel it is important to emphasize that changes in implied volatility are only tendencies and are ultimately driven by supply and demand factors, but it is important to bear these points in mind should you choose to initiate this type of position.

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