Part 2: Vertical Spreads For Futures Option Trading

By selecting an at-the-money option to sell as part of a vertical futures option trading spread, an investor can execute a time decay play with a hedged position.

Much in the same way that a vertical futures option trading spread can be used as a time decay play, it can be used as a volatility play. We stated earlier that an at-the-money option has more extrinsic value than any other option in its expiration month. This is due to a number of contributing factors including time but it is in no small way due to volatility.

Volatility is a huge component of an futures option trading extrinsic value. An option’s dollar sensitivity to movements in implied volatility is known as vega. Obviously, an at-the-money option will have a higher vega (volatility sensitivity) then will an in-the-money or out-of-the-money option in the same month.

As volatility increases, the at-the-money option will increase in price to a greater degree than will an in-the-money or out-of-the-money option in the same month. As volatility increases, the at-the-money futures option trading value will increase in price to a greater degree then will an in-the-money or out-of-the-money option whose vega’s will be less.

Conversely, the at-the-money futures option trading will lose value at a greater rate than an in-the-money or out-of-the-money option should implied volatility decrease. The question now is how to use the vertical spread to take advantage of anticipated movements in implied volatility. Remember, the vertical spread affords you the luxury of being hedged on either side of the trade – both as a buyer and a seller of the futures option trading spread.

So, if you think that implied volatility is likely to increase, you can set up a vertical spread by buying an at-the-money option and selling either the in-the-money or out-of-the-money option against it. Conversely, if you feel implied volatility will decrease; you can set up a vertical futures option trading spread by selling an at-the-money option and buy either an out-of-the-money or an in-the-money option against it.

As to how to set it up, you would follow the same guidelines as you would for setting up a vertical futures option trading spread to take advantage of time decay. Decide which direction you feel the futures option trading would most likely move. If you feel the stock would most likely rise, you will have to decide between buying a vertical call spread and selling a vertical put spread.

Either way, the futures option trading spread will have to be constructed with the at-the-money option being long if you feel volatility will increase or short if you feel volatility will decrease. If you feel the stock would most likely fall, you will have to decide between buying a vertical put spread and selling a vertical call spread. Again, either way, the futures option trading spread will have to be constructed with the short option being the at-the-money.

As you can see, the vertical futures option trading spread does not have to be used only in directional scenarios. It is very versatile allowing the investor several choices among a diverse group of potential uses. It also affords limited risk, albeit limited profit potential, to both the buyer and the seller.