Choosing The Right Long Vertical Spread

If IV is low (IV rank <30 and coupled with an IV of less than 40%), one may consider opportunistic trades using debit vertical debit spread. One source defines debit vertical spread as “The vertical debit spread refers to a vertical spread whereby a net debit is taken to enter the trade. A bullish vertical debit spread can be constructed using call options and is known as the bull call spread. A bearish vertical debit spread can be created using put options and is known as the bear put spread.”

Question – which debit vertical spread should we consider?

I decided to look at SPY as an underlying to try to understand this question. For me, it is very important since I have a small account. Need to balance between risk and return. Using SPY (19 March 2021) – it has IV rank of 10.8 and IV of 23% which may be conducive for debit vertical spread. I generated a number of options strategies using different strike with different width.

Extracted from TastyWorks platform on 7 Feb 2021

As shown in the above table (debit call spreads), I learn the following key points:

  • If you have a small account, do consider option strategies with defined risks. For debit vertical spreads, I personally try to cap my option width to not more than $1 (i tend to adopt higher width when comes to selling options);
  • For lower OTM (%) of 30% and below, the return on capital ROC is generally lower but they have a higher POP. Would this be an efficient use of your capital? E.g for OTM16%, the ROC is less than 10%. When I feel risk adverse about this particular trade, I may go for a higher OTM (may be 30-40%, but not too close to ATM)
  • If I am confident with the trade, I may consider debit call spread closer to ATM such as the debit call spread – for example debit call spread for SPY at 387/388 and 386/387 (with ROC > 50% and P50> 70%)

What does “being confident” mean?

As tenure of options is relatively short up to max 45 – 60 day DTE, technical analysis plays a key role. As long there are clear signals for breakout / reversal – this increase my level of confidence. Fundamentally, there has to be some positive or negative developments impacting the company (e.g earnings surprise / rating upgrade / new projects or expansion plans /etc).

DISCLAIMER: This is not investment / trading advice or endorsement. Please refer to the general disclaimer of this blog. If in doubt, please consult with your licensed financial planner / adviser.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s