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Options Trading Lesson: Volatility

Jan 8, 2008
To get a firm grasp of volatility's effect on vertical spreads, let us examine three spreads against different implied volatilities while keeping the stock price constant at 67.5. These are the 60 - 65, 65 - 70 and 70 - 75 call spreads.

In-the-Money Vertical Spreads
Looking at the in-the-money spread (June 60 - 65), we see that as volatility increases, the value of the spread decreases. This is because with the increased volatility, the stock has a greater tendency to move. That brings a higher probability 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 spread will have less value. A general rule of thumb is that as volatility increases, the value of an in-the-money vertical spread decreases. Conversely, an in-the-money vertical spread's value increases as volatility decreases.

At-the-Money Vertical Spreads
A change in volatility has very little effect on the at-the-money vertical spread (June 65 - 70). With the stock price located equidistant from the two strikes, each strike's volatility component will be very similar. Therefore, both options will increase equally once volatility increases. Being long on one and short on the other, the increase in values will offset each other so the spread's value will hold fairly constant. When volatility increases or decreases, the value of an at-the-money vertical spread will stay reasonably constant.

Out-of-the-Money Vertical Spreads
The out-of-the-money vertical spread (June 70 - 75) has the opposite effect of the in-the-money vertical spread (June 60 - 65). As volatility increases, the value of the out-of-the-money vertical spread will increase. This is because the increase in volatility assumes that the stock price is more likely to move. Thus, the out-of-the-money vertical call spread is more likely to finish in-the-money.

Because of this spread's increased potential to finish in-the-money, its value will increase. The spread's value will decrease if volatility decreases. On the other hand, an out-of-the-money vertical spread's value increases when volatility increases.

When trying to estimate how your spread will change in price with volatility movement, you must understand how the price and Delta of both of your options - long and short - will act.

It bears repeating again that each spread is different and will act differently depending on where the stock is in relation to the spread and what implied volatility does.

Median Value
An important thing to note is that when volatility increases, spreads crunch to their median value. For example, the median value of a $5.00 spread will be $2.50 while a $10.00 spread will have a $5.00 median value.

Crunching to the median value means that a $5.00 spread with a median value over $2.50 will lose value and head toward the median price. That happens with an increase in volatility. Meanwhile, increased implied volatility will make a spread with a value less than $2.50, increase in value and rise toward median value.

When implied volatility decreases, the value of a $5.00 spread will move away from the median price of $2.50. Therefore, when implied volatility decreases, all the spreads valued above $2.50 will increase in value toward maximum value. Spreads valued below $2.50 will lose value and head toward $0.

The Effect of Time
Time affects the spread differently depending on where the stock is. Look at the QCOM 65 - 70 call spread. Look at the spread's reaction to the passing of time with the stock price of $65.50.

The chart below shows what the spread's value does as expiration approaches.

Month Months to Expiration 65 - 70 call spread value Change from prior
Jan. 05 (8 month option) 2.06 N/A
Oct. 04 (5 month option) 2.05 -.01
Jul. 04 (2 month option) 1.92 -.13
June 04 (1 month option) 1.65 -.27

With the stock at $65.50, the spread has $.50 of intrinsic value. Holding the stock price frozen at $65.50 until expiration, the spread would be worth $.50. The table above shows that the spread loses value as time passes and decreases in value toward its $.50 intrinsic value.

Next, look at the 65 - 70 spread's reaction to the passage of time with the stock priced at $67.50.

Month Months to Expiration 65 - 70 call spread value Change from prior
Jan. 05 (8 month option) 2.33 N/A
Oct. 04 (5 month option) 2.37 +.04
Jul. 04 (2 month option) 2.44 +.07
June 04 (1 month option) 2.47 +.03

With the stock price located directly in between the two strikes, the price of the spread holds at approximately $2.50 throughout the passing of time. Take note that time has very little effect on a vertical spread when the stock price lies halfway (equidistant) between the two strikes of the spread.

Now, set the stock price at $69.50 and observe how the spread reacts over time.

Month Months to Expiration 65 - 70 call spread value Change from prior
Jan. 05 (8 month option) 2.55 N/A
Oct. 04 (5 month option) 2.67 +.12
Jul. 04 (2 month option) 2.96 +.29
June 04 (1 month option) 3.27 +.31

This spread increases in value as time passes. With the stock at $69.50, the spread has an intrinsic value of $4.50. If the stock held at $69.50 until expiration, the spread would be worth $4.50 because that is the amount of the spread's intrinsic value. As time passes, the spread's value will increase to finally reach $4.50 at expiration.

In conclusion, time's effect on a vertical spread is contingent on where the stock is in relation to the spread.
About the Author
Ron Ianieri is currently Chief Options Strategist at The Options University, an educational company that teaches investors how to make consistent profits using options while limiting risk. For more information please contact The Options University at http://www.optionsuniversity.com or 866-561-8227
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