Part 1: Vertical Spreads For Futures Option Trading

When vertical futures option trading spreads are mentioned, they quite often come with monikers such as “bull” and “bear”. This lends most to think of vertical futures option trading spreads as directional plays, which is true. However, vertical spreads can be used to take advantage of two other potential trading opportunities – time decay and volatility movement.

If you are looking for a fully hedged way to take advantage of time decay, a vertical futures option trading spread can be an excellent tool. Knowing a little about them now, you will recall that a vertical futures option trading spread has a limited profit potential but also a limited loss scenario for both the buyer and the seller. So, how do we use this covered trade to take advantage of time decay.

At-the-money options have more extrinsic value than their similar month in-the-money or out-of-the-money options. Since it is an option’s extrinsic value that decays away over time, you could set up a vertical futures option trading spread by selling an at-the-money option and buying either the out-of-the-money option (creating a credit spread) or buying an in-the-money option (creating a debit spread).

If the stock holds tight to the out-of-the-money option, the futures option trading extrinsic value will decay away at a faster rate than either the in-the-money option or the out-of-the-money option due to the fact that the at-the-money option has more total extrinsic value to decay in the same amount of time as the others.

Creating the vertical futures option trading spread by selling an at-the-money option and buying an out-of-the-money or in-the-money option as a hedge looks like a good idea, but now there are a couple choices. Should you do the put spread or the call spread? Should you buy it or sell it? The decision of what to do from here should first be based on which way you think the stock will move. Although you are playing for time decay and you are assuming an overall lack of movement, you can’t expect the stock not to move at all.

So even though you are playing time decay, you still want to form an opinion about in which direction the stock is most likely to move. By doing this, you’ve now give yourself another way of making the trade profitable. You are playing for a lack of movement but now you can still win if you pick the right direction. This scenario presents you with two ways to win and only one to lose.

Now that you have picked which at-the-money strike you are going to sell and you’ve picked your anticipated stock position you still have a decision to make. Do you do the call vertical futures option trading spread or the put vertical spread? Remember both the vertical call spread and a vertical put spread allow you to participate in either stock direction. For the bulls, you can buy a vertical call spread or sell a vertical if you think that the futures option trading value will go up.

For the bears, you can buy a vertical put spread or sell a vertical futures option trading call spread. For each direction there are two choices to decide from. One is a purchase, one is a sale. The best way to decide which to do, other than your own style or comfort ability is a simple risk/reward analysis.