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 options 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
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 cant 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, youve 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
Now that you have picked which at-the-money strike you are going
to sell and youve 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.