Abstract
Option spread trades can be set up in a variety of different ways and offer flexibility for an investor to target specific goals in terms of risk-return profile. I study different setups of Bull spread trades with Calls to illustrate which setups are largely directional trades and which setups are largely volatility trades. Analytical derivations reveal that setups involving short positions in out-the-money Calls offer the strongest directional plays, whereas other setups are mostly long or short volatility. An analysis of spread returns using S&P 500 Index options data reveals high average returns, strong negative skewness in short volatility setups, and positive skewness in long volatility setups. Returns are heavily affected by costs of trading, but setups including short positions in out-the-money Calls return strong average returns even after costs. Factor analysis reveals that positive alpha is more readily obtained for trades held until maturity rather than for trades closed out before maturity.
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Notes
For work on theoretical expected returns see Coval and Shumway (2001). See Wilkens (2007), McKeon (2013) and related papers for work showing how empirical realized returns depart from theory.
These trades will be abbreviated ATM/OTM in the remainder of the paper. Other constructions will be similarly abbreviated, for example, ITM/OTM for long in-the-money, short out-the-money and so on.
Details of the derivations for the other setups are available from the author on request.
Changes in time value are, of course, influenced by movements in the price of the underlyer. However, effects on time value from such price movements would not be as direct and reliable as effects on intrinsic value.
These screens included eliminating options with comparatively wide Bid-Ask spreads, or zero trading volume, and option prices that were violating known option pricing rules for minimum or maximum values or Put–Call parity.
In this article, negative theta indicates that time value declines as time passes and positive theta indicates that time value increases as time passes ceteris paribus. This is important to note because sometimes writers use positive theta for time value decay (because there is a positive relationship: less time means lower time value).
The specific trade is from 1 April 2013 to 17 May 2013, when the S&P 500 rose from 1562.17 to 1667.47. The spread involved a long position in the 1640 Call (original Bid/Ask of $1/$1.35; value at expiry of $27.47) and a short position in the 1690 Call (original Bid/Ask of $0.10/$0.45; value at expiry of $0).
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Acknowledgements
The author would like to thank his former student Chris Douglas, currently a Masters candidate in Financial Engineering at the Claremont Graduate School, for valuable analytical work that helped shape the article.
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McKeon, R. Option spread trades: Returns on directional and volatility trades. J Asset Manag 17, 422–433 (2016). https://doi.org/10.1057/jam.2016.6
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DOI: https://doi.org/10.1057/jam.2016.6