Part 1: Vertical stock Options Spread

Provided By Options University

Factors That Affect Stock Options Spread Pricing

The determination of stock options spread pricing as described above works in most cases but please be aware that this assumes that the implied volatility in both the 35 and 40 calls is the same. Most of the time, these two options will have a slightly different implied volatility.

This intra-month difference in implied volatility values through different strikes is known as a vertical volatility skew. The reason the markets run volatility skews is to make sure that the out-of-the-money stock options spread have enough premium in them to justify the individual option’s risk/reward scenario.

For now, it is enough to know that there is a volatility skew, but as long as it is a tight skew (little deviation of implied volatility from strike to strike) the values should hold pretty consistent in our previous examples.

Whatever factors effect the vertical stock options spread, they are contingent on where the stock is in relation to the stock options spread. Changes in implied volatility affect the price of a spread as stated above but the position of the stock in relation to the strikes of the stock options spread are a key determinate of price.

Volatility & The Stock Options Spread

To get a good feel for volatility’s effect on the vertical stock options spread, we will look at three different spreads, against three different implied volatilities while keeping the stock price constant at 67 ½. The three spreads we will be looking at will be the 60 – 65 call stock options spread, the 65- 70 call spread and the 70 – 75 call spread.

30 Vol.
$ Amount Change
40 Vol.
$ Amount Change
50 Vol.
$ Amount Change
June 60-65 ITM
June 65-70 AITM
June 70-75 OTM

Looking at the chart we observe how volatility movements affect in-the-money, at-the-money and the out-of-the-money vertical stock options spread.

Looking at the in-the-money stock options spread (June 60 – 65) we see that as volatility increases, the value of the stock options spread decreases. This is because with the increased volatility, the stock will have a greater tendency to move around and that will bring a higher likelihood of the stock moving to a price where the June 60 – 65 call spread will no longer be in-the-money.

To adjust for higher volatility risk, the stock options spread will have less value. The rule of thumb is that as volatility increases, the value of in-the-money vertical stock options spread decreases. Vice-versa, as volatility decreases, an in-the-money vertical stock options spread value increases.

The at-the-money vertical stock options spread (June 65 – 70) will see very little effect with the change in volatility. With the stock price located equidistant from the two strikes, each strike’s volatility component will be very similar. Thus, when volatility increases both options will increase equally. Being long one and short the other, the increase in values will offset each other so the stock options spread value will hold pretty constant. The rule of thumb is that when volatility increases or decreases, the value of an at-the-money vertical stock options spread will stay reasonably constant.

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