Butterfly Options » Investments

Trading the Markets and the Financial Recovery

admin — Thu, 07 Jan 2010 14:28:02 +0000

With the world in recovery mode, many people are still questioning how the financial markets got so out of control. They are also questioning something a little closer to home; how to better look after their own money and finances.If we are being honest with ourselves, we would probably admit that we can improve on at least one of the following; long term investments, tax efficiency, actively reviewing our existing investments and looking at new opportunities that the markets in 2009-2010 have provided / will provide.Also, I don’t think that there are many of us who wouldn’t benefit from putting more thought and effort into these key areas. Having said that, there are a growing number of individuals who are making use of a newer, and highly regulated, form of trading.One type of trading, namely financial spread betting, has a range of attractive features and is an option worth considering as part of your portfolio.When speculating though you must always remind yourself that the markets can go down as well as up. With spread betting you can lose more than your original stake or investment.But why trade if there is a risk?Whether you have an existing investment plan or not, it always worth considering any avenue that offers quick, simple access to the markets and a range of tax-free* advantages. Spread betting is one such avenue.Of the many other advantages, spread betting profits do not incur capital gains tax*. You are not actually buying and selling any assets or stock or shares. You are simply speculating on the future price or value of a financial market.A boon for many spread bettors is the sheer convenience of trading over the phone and online, even after the main stock markets and futures exchanges have closed.Another plus point is that there may be occasions when an investor wishes to close a spread bet early. This can work in two ways. It can help you limit a losing position or it can also help you lock in profits on a winning trade.The Financial Services Authority regulates the spread betting companies. This helps to ensure a certain level of quality or, more importantly, financial protection. With regulated companies like paddypowertrader you can trade some markets 24 hours a day, including key Forex and Stock Market Index markets. Naturally, you can also trade Crude Oil, Gold, UK and US shares and so on.So whilst there are a good number of positives, it is important to understand the negatives.Spread bets do carry a high level of risk so you should only speculate with money you can afford to lose. Before you trade, please ensure that spread betting matches your investment objectives, make sure you familiarise yourself with the risks involved and seek independent advice where necessary.* Based on current UK Tax law. If you pay tax in a jurisdiction other than the UK then this may be different.

Option Expiration and Exercise

admin — Thu, 24 Dec 2009 00:13:36 +0000

Beginning options traders often make costly mistakes due to either a lack of knowledge or misinformation about the basic parameters of options and their exercise. Examples of common errors include being surprised that one is unable to close an index option position on the Friday before expiration, or being surprised by an unhedged option exercise during expiration. This paper covers some of the basic concepts surrounding option expiration and how options are exercised. Be sure you understand the settlement, exercise, and expiration characteristics of the options you trade.Option ExpirationEquity options expire on the Saturday following the third Friday of each month. It is common to hear or read that equity options expire on that third Friday. While that isn’t technically correct, it is true that Friday is the last opportunity to trade those options. Saturday expiration was established to give the brokerages time to settle the accounts before the options technically (legally) lose their value.However, some (but not all) index options cease trading at the close on the Thursday prior to expiration and those positions are reconciled on Saturday based upon the settlement price established on Friday. For example, the SPX index options cannot be traded after the close on the Thursday before expiration; but the settlement price, usually reported as SET or $SET, is established Friday morning based on the opening price of each of the 500 S&P stocks. Since many stocks do not open immediately at the opening bell, the settlement price will differ from the SPX opening price on Friday. Option ExerciseThe owner of an equity option has the right to buy or sell 100 shares of the underlying stock anytime before expiration. If you are long the option (i.e., you originally bought it), you may or may not choose to exercise the option you own; it is entirely your choice. If you are short the option (i.e., you originally sold the option), it may be exercised against you at any time. Typically, you will receive an email from your broker after the market close, notifying you of the exercise. You may be exercised for only a portion of your option position, e.g., only 2 of your 10 contracts. If you were short call options, you will now see a short stock position in your account, i.e., you were obligated to sell the stock at the strike price. If you were short put options, the exercise forces you to buy stock at the strike price, resulting in a long stock position in your account. When options contracts are first created, exercise is specified in one of two different ways: American style or European style. American style options can be exercised on any business day prior to expiration, whereas European style options can only be exercised at expiration. All equity options are subject to exercise American style, while most index options are European style, e.g., the SPX. But there are some exceptions with a small number of index options settling American style, e.g., the OEX.Upon expiration, your broker will automatically exercise any expiring options in your account that are $0.05 or more ITM (in the money) in accordance with Options Clearing Corporation regulations. If expiration is approaching and the stock price is near your strike price, and you do not want to hold either the long or short stock position that will result from the exercise of your long option, sell the option before the market closes on the Friday of expiration week. If you are holding a European style index option position and wish to close it before expiration, be sure to complete those orders before the market closes on Thursday before expiration. If you wish to exercise any of your long equity options, you must issue an order to your broker before the market closes on the Friday of expiration week. It is generally good practice to close option positions before expiration to avoid unpleasant surprises.Option spread positions always have a short option position by definition, so they are subject to exercise at any time. However, the long option protects you in this situation, e.g., if I am holding a 10 contract spread and I receive a notice of exercise from my broker for 3 of the short options, I simply ask my broker to exercise 3 of my long options to cover the exercise.In practice, it is rare that your short option positions will be exercised against you before expiration. But, as noted above, your long option position protects you against this exercise. In general, put options are rarely exercised unless there is less than $0.10 of time value left in the option. The same is true of call options with one major exception: calls are often exercised just before a stock goes ex-dividend, e.g., if the call has $0.10 of time value remaining, but the dividend is $0.50 per share, it may be advantageous to the option owner to exercise the option and hold the stock through the ex-dividend date to collect the dividend payment. Sometimes an option will be exercised against you in a situation where it makes no sense whatsoever and is probably a mistake or due to inexperience of the person on the other side of the trade.If you are holding a vertical spread position going into expiration, there are several different situations possible. If both of the options are fully in the money, your broker will automatically exercise both of the long and short options and credit your account with the spread amount less commissions. However, if the stock price closes expiration Friday within the spread, the situation is a little tricky and the results may surprise you. For example, if we were holding a bull call spread, the short OTM call will expire worthless and the broker will exercise the long call on your behalf, resulting in shares of stock in your account the following Monday (and perhaps a call from your broker if your account does not have sufficient cash to buy the stock). If you do not want to purchase the stock, you should close the spread before the market close on the Friday of expiration week.Credit spreads can also result in surprises at expiration. For example, if I hold a bull put spread and the underlying stock closes Friday of expiration week at a price within the spread, my short put options will be exercised against me, resulting in a long stock position in my account. The long put option does not protect me because it expired worthless.In general, if the stock price closes on expiration Friday within the strike prices of my vertical spread, it will result in either a long stock position or a short stock position in my account the following Monday. Unless you are willing to hold that stock position, it is usually best to close the spread on Friday. Many traders adopt a general rule of closing all option positions the week before expiration to avoid the surprises that are all too common the week of expiration.

Trading the Infamous Iron Condor

admin — Sun, 20 Dec 2009 13:11:17 +0000

Placing iron condor spreads on the broad market indexes is a relatively conservative, non-directional trading strategy that may be used for consistent income generation. This strategy profits as long as the index trades within the channel formed by the two spread positions. It is best used during sideways or slowly trending markets.Condor SpreadsA condor spread is a debit spread, established by placing a bear call spread at or above resistance and placing a bull call spread at or below support. The condor may also be established using puts with a bear put spread above and a bull put spread below. The iron condor is a variation on this trade by using a bear call spread above and a bull put spread below the price of the underlying stock or index. The iron condor is a credit spread and achieves maximum profitability if the price of the underlying closes between the short options (the strike prices we sold) of the two spreads at expiration. In that case, all options expire worthless and you achieve the maximum profit, i.e., the credits originally collected. The profitability of the iron condor is assisted by the fact that the broker only requires margin for one of the credit spreads, effectively doubling the return on investment.Condor spreads are effective when the underlying is expected to trade within the channel defined by the spreads during the life of the options. The closer one places the spreads to the current price of the underlying, the higher the returns; however, this comes with a higher risk of the price of the underlying stock or index entering one of the spreads and causing a loss on that spread.Trading the stock indexes with condors is effective for several reasons: 1) the indexes generally move slower than most individual stocks, 2) the indexes are less affected by an individual stock’s bad news, 3) the premiums of the index options are generally much higher than individual stock options, 4) index options trade in high volume because large institutional investors use these options to hedge their portfolios; this results in high liquidity, and 5) 60% of the gains with broad index options are taxed at long term capital gains rates, regardless of the length of time in the trade. Money ManagementMoney management refers to the rules used for determining the amount of capital devoted to a trade and spreading risk among strike prices and time. Determine the total dollar value you wish to devote to this strategy. For this example, we will assume we have a $100,000 account we will exclusively trade using the iron condor strategy. Take 40% of the total portfolio ($40,000) and divide by $1000 to get 40. This is the total number of contracts you will trade in this strategy each month (40 contracts total in the bear call spreads and 40 contracts total in the bull put spreads). This approach lessens your exposure during any particular month and leaves you room in the account to put on next month’s positions before last month’s positions have expired. This also reserves an additional 20% of capital as a safety margin and for possible use in trade adjustments. IMPORTANT: when learning this or any options trading strategy, start very small with one or two contracts and gradually increase your size as your experience and confidence grow.Money management also includes the concept of limiting your losses. Playing iron condors on the indexes as outlined in this paper are conservative, high probability trades. However, the potential loss is quite large, even though the loss has a low probability of occurrence. Therefore, one loss may wipe out several months of profits. Stop loss and adjustment rules and the discipline to strictly follow them are critical to the success of trading iron condors. Those stop loss and adjustment systems are taught in detail in the Advanced Options Trading Strategies course offered by Parkwood Capital, LLC.Timing (Days to Expiration)You can establish your condor position sometime in the range of 40 to 50 days until expiration. The precise time is not critical. The trade-offs are as follows: the earlier I put on my spread positions, the more time premium is present in the options and therefore I can receive the minimum credit I am willing to accept farther out from the current levels of the index; therefore, more safety margin is achieved. However, the more time I use in the spread, the more time that exists for the market to move against me; thus, I am incurring more risk. As time decay reduces the option premiums, I must move my spreads in closer to achieve a reasonable credit, reducing my safety margin and increasing my risk. It is also possible to trade the iron condor starting at about 30 days to expiration, but the system rules and adjustments must be adjusted accordingly.Determining Optimal Entry PointsSome traders place the call spreads when the index is hitting resistance and appears to be turning down, and place the put spreads when the index is hitting support and appears to be turning back upward. This will maximize the size of your credits. However, if the index continues to move in that direction, your position could be in trouble quickly and you will not have the compensating spread position helping to hedge your position. For this reason, I generally establish both the call spreads and put spreads on the same day.Choosing the StrikesWe can apply basic statistics to our deciding which strike prices are “far enough” out to be safe. The classic “bell shaped curve” we have seen in various contexts is the mathematical function known as a normal or Gaussian distribution. If we assume that future moves of the index price will be random and similar in frequency and absolute size to previous fluctuations up and down, then we can calculate the probability of the index price being at a particular price on a particular date in the future. I calculate the standard deviation for the index, based upon its level of implied volatility and the time left to expiration. The call spreads are placed just outside one standard deviation above the index price and the put spreads are placed just below one standard deviation below the index price. This results in an iron condor position with a probability of success of approximately 80-85%. The details of this methodology are taught in the Equity and Index Options course offered by Parkwood Capital, LLC.Entering the Order and Getting FilledNow that we have determined the strike prices for our spread, we need to calculate the credit we are going to ask for in our order. Compute the natural price for the credit spread, the natural debit spread price, and the midpoint of the spread (most online brokers calculate this for you).Enter your order at a credit limit at the midpoint and wait to see if the order is filled. After a few minutes, adjust the credit downward by $0.05. Repeat until both spread orders are filled. But do not drop below the lower quartile of the bid/ask spread.Never place an order for less than $0.60 to $0.70 in credit; trading commissions become too large a factor for smaller credits. My spread credits normally range from $0.60 to $1.05 per spread or about $1.20 to $2.10 per iron condor.Stop Losses and AdjustmentsThe topics of setting stop losses and the variety of adjustment methodologies available are beyond the scope of this paper. An effective, but simple, risk management technique is to monitor the debit spread necessary to close your condor spreads, and when that debit is double the original credit received for that spread, close that side of the condor. This technique will close out positions more frequently, but it will result in very small losses or near breakeven results in the “bad” months when the index moves against you.Index Option SettlementIndex options are cash settled options; there is no underlying instrument like stock shares to be called away or put to you. You simply lose or gain the dollar value at expiration, e.g., you hold 10 contracts of the $1400 call and the SPX settlement price is $1405; your account will be credited with $5,000 ((1405 – 1400) x 100 x 10). If you were short the $1400 calls, your account would be debited $5,000.Most index options are somewhat unusual in that they cease trading for the month at market close (4:15 pm ET) on the Thursday before expiration, but the settlement price is not that closing price on Thursday or the opening price Friday morning. Therefore, all final adjustments to positions must be done on Thursday before the close. On Friday morning, the settlement price will be computed based upon the opening prices of each of the stocks that make up that index. Since each stock may not trade immediately at the open, the settlement value may not be available until later that Friday morning. Since the settlement price may vary several dollars up or down from Thursday’s close, one must be cautious about going into settlement with any spread positions remaining open.Expected ReturnsIf you are placing your spreads for credits of $0.70 or more, then the returns for that iron condor will be about 15% for the month (remember that margin is only charged for one half of the iron condor). If we are using roughly half of our capital for an iron condor each month, then you can expect to average returns of about 6% to 8% per month. Of course, you may have to defensively close one of the spreads a few times per year and that will reduce the annualized return of this strategy. SummaryThe iron condor trading strategy is a relatively conservative, non-directional options strategy that may be used for consistent income. However, this strategy is typical of low return strategies with high probabilities of success. The probability of a loss is small, but one large loss will wipe out several months of profits. Thus, the key to success for trading iron condors is solid risk management rules for entry and exit, stop losses, and adjustments. When deployed conservatively as outlined herein, this strategy should reasonably be expected to return 5% or more per month.

Beware the Hype in Options Trading

admin — Thu, 17 Dec 2009 11:41:52 +0000

Selling education on options trading is a big business. We see infomercials on television and receive emails advertising free trading software and foolproof trading systems. Unfortunately, there are many “snake oil salesmen” operating in options education. They are busy selling the dream of instantaneous riches without effort – and their price tag isn’t cheap.I recently came across the following statements on option education web sites or advertisements for those web sites:

Make all the money you ever dreamed of trading options! Trade options like a pro tomorrow! Want to make 627% trading options?

The first statement doesn’t even deserve comment. The second statement is extremely misleading. It is certainly true that ordinary people of average intelligence can learn how to trade options – but it won’t happen tomorrow! Learning the fundamentals of options terminology, how options trade, how they are priced, and then all of the different options trading strategies and their behavior in differing markets simply does not happen overnight. It requires time, effort, and practice. In my experience, a minimum of six months is required for the fundamental education, paper trading, and then some taste of success trading in small lots before scaling up in volume.The advertising line, “Want to make 627% trading options?”, is preposterous, but apparently it sells and brings in people. Certainly, it is possible to make returns of several hundred percent trading options. But it is also true that you could easily lose 100% of your money very quickly if you did not know what you were doing. Options trading strategies with the potential of several hundred percent returns are inherently trades with low probabilities of success. So, yes, I would like to make 627% trading options, but the presumption in this advertisement is that you can do that on most, if not all, of your trades. That is simply not true.If you are interested in learning to trade options, here is a checklist to ensure your success:1. Find a reputable options education firm.2. Continue your search if the options education firm hypes the potential returns or suggests this will be quick and easy. 3. Check references from former students.4. Expect to spend at least three months learning the fundamentals and trading on paper.5. Hire a trading coach who will be on call to help and answer questions as you begin to trade with real money (this will actually save you money).6. Scale up slowly.Learning to trade options and generate a steady income from the markets is indeed feasible. But it requires time, effort, practice, discipline, and coaching to be successful. Don’t be deceived by the hype.

Spread Betting on the Financial Markets

admin — Fri, 04 Dec 2009 01:41:15 +0000

Are you looking for a safer entry route in the capital markets? In the last few years there has been a lot of innovation in the financial markets; some good, some not so good. So what markets to trade and, more importantly, how to trade them?One option is spread betting, in the past this form of trading has had a reputation of letting you make quick profits and even quicker losses. It was always a bit of a rollercoaster. The leading spread betting companies have now introduced a number of ways to help to restrict your losses. Spread betting is a quick and tax free* method of trading and, therefore, it does have its appealing aspects. These days though, with financial spread trading, you can limit your downside. Of course, as with all investments you should exercise more than a little caution.Spread betting on the financial markets offers more than just tax based advantages. For example, you can enter into a trade to buy or sell shares without actually owning them. So if you think a share will perform poorly you can speculate on it to go down. This is also known as ‘shorting’.You can also bet against a wide range of other markets eg you can spread bet on Gold, Crude Oil, the FTSE 100, Dollar/Euro, Pound/Yen etc to go down. Naturally, you can also speculate on these markets and thousands of others to go up.Personally, I also like the fault that the whole process is regulated in the UK by the Financial Services Authority. This helps ensure your funds remain safe.If you financial spread bet, the range of possibilities is quite impressive and growing by the day. As you can see from the above, you can trade shares, forex, commodities and indices. More recently you have been able to trade bonds, interest rates and even house prices. Financial spread trading is based on speculation of the future movements of the markets. Hence there is an inherent risk associated with the decisions you may undertake. However, there are various methods available in order to reduce your risk. One such option is the Guaranteed Stop Loss order. This is an automated order that ensures that your losses are limited. It can also be wise to trade in small stakes as this is a simple way of reducing your risk.Note that spread betting carries a high level of risk and may not be suitable for all classes of investor. Only trade with money that you can afford to lose. Make sure you fully understand the risks involved. If necessary, seek independent financial advice.* Tax law is subject to change and may differ in jurisdiction outside Ireland or the UK.

Put Time On Your Side

admin — Thu, 03 Dec 2009 13:23:41 +0000

Many conservative income generation trading strategies depend on the time decay inherent in options pricing. When I establish an iron condor well OTM (out of the money), I am selling option spreads and expecting those spreads to slowly lose value as the underlying stock or index trades within a channel. Other traders may use butterfly spreads or place OTM credit spreads on one side only (calls or puts); all of these trades are based on time decay working in the trader’s favor. This is in contrast to the long option position designed to benefit from my prediction of a particular directional move for the underlying index or stock. Those positions lose value over time if the predicted move does not occur, so time is not your friend for those trades.

One of the items on your checklist before making a trade should be a glance at the calendar to see if any exchange holidays are upcoming. When time decay is on your side, exchange holidays are also your friend. If the market isn’t open, it can’t move against your positions, but time decay is still occurring and improving the profitability of your position. I will often establish my OTM credit spread positions before long holiday weekends to add to my edge.Another important factor to keep in mind is the historical seasonality of volatility. Trading activity slows during several of the holidays every year, as traders take time off to be with their families and exchange business tends to slow. March and October have historically displayed the highest volatility for the year, whereas the summer months and the week between Christmas and New Year’s Day are historically slow periods of market activity. An old wall street maxim is “sell in May and go away.” It refers to the tendencies for many market participants to take vacations and long weekends over the summer, resulting in lower trading volumes and lower volatility. This tends to favor strategies like iron condors that benefit from slower moving, sideways markets.Another factor tracked by many traders is which monthly options cycles have 5 weeks and which only have 4 weeks. Option prices will be skewed because of the number of days in an option cycle. If your trading style involves consistently selling premium each option cycle, you should be aware of the five week option months, since the amount of premium income may be affected.Options trading strategies that benefit from the time decay of options prices are attractive for monthly income generation. Pay attention to the calendar and put time on your side.

Vertical Spreads and Implied Volatility

admin — Sun, 29 Nov 2009 12:51:44 +0000

One will commonly hear or read the following “rule of thumb” for options spread trading:When implied volatility is high, sell credit spreads and when implied volatility is low, buy debit spreads.Unfortunately, this is simply not true. The credit spread and its corresponding debit spread at the same strike prices will always have virtually identical returns on investment (ROI). This paper addresses the role of implied volatility in the vertical spread, both at initiation and over the course of the trade.BackgroundVertical spreads derive their name from the wall originally used to display option prices when they were first traded in Chicago many years ago. The months of expiration were displayed horizontally across the top of the board and the strike prices were displayed vertically along the left edge. Thus, spread trades using two options at two different strike prices in the same expiration month were in the same column and thus constituted a vertical spread. This includes bull call, bear call, bull put, and bear put spreads.Similarly, horizontal spreads are created by buying and selling options from the same row – different months of expiration, but with the same strike price. Horizontal spreads are also known as calendar spreads or time spreads.Diagonal spreads are created when different strike prices and different expiration months are used – thus, a diagonal line across the board between the option sold and the option purchased. An example would be buying the September $300 GOOG call and selling the July $320 GOOG call to create a diagonal bull call spread.Vertical spreads either require a net investment to initiate (a debit spread) or we initially receive money into our account (a credit spread). For this reason, it is common terminology for us to say we are “buying a call spread” when establishing a debit spread and “selling a call spread” to refer to initiating a credit spread. Bull call spreads are created by buying a call and selling another call at a higher strike, or farther OTM (a debit spread). A bear call spread is created by buying a call and selling a lower strike price call, or farther ITM (a credit spread). Similarly, a bear put spread is established by buying a put and selling the lower strike price put that is farther OTM (a debit spread). And a bull put spread consists of buying a put and selling another put at a higher strike price, farther ITM (a credit spread). Credit or Debit?There are many decisions made before we put on a trade, but for this discussion we will assume that a vertical spread strategy has been chosen as the optimal trading strategy for this situation. The next decision is whether to use a credit or a debit spread. The maximum potential gain for the vertical spread, all variables held constant except the choice of calls or puts, will be indifferent to whether the trade is established as a credit or debit spread. For example:GOOG closed at $310.71 on October 5, 2005. If one were bullish on this stock, one could place an Oct $310/$320 bull call spread for a debit of $430 ($960 – $530) and a maximum potential gain of 133%, assuming expiration with GOOG trading above $320.Similarly, one could place an Oct $310/$320 bull put spread for a credit of $560 ($1400 – $840) and a maximum potential gain of 127%, assuming expiration with GOOG above $320.The small difference between the two returns is insignificant; we are using the closing bid and ask prices for these options, and the option prices are very fluid, so picking prices at any arbitrary point and getting exactly identical results would be unusual. The conclusion is that any difference in returns between a credit and debit spread for the same underlying stock, strike prices, and expiration month will be small and temporary, because market forces will quickly adjust them to parity.It is commonly taught that one should establish a credit spread when placing a trade with high implied volatility (IV) options and a debit spread with low IV options. But the previous example illustrated identical returns for the credit and debit spreads. So, in that example, we would be indifferent to placing a debit or a credit spread. But let’s take it a step further.We will use the Black-Scholes model to compute the theoretical prices of the GOOG $310 and $320 options from the previous example, but with IV boosted up to 60% (the actual IV values in the above example ranged from 33% to 34%). Now the spread values become:The Oct $310/$320 bull call spread could be placed for a debit of $436 ($1613 – $1177) and a maximum potential gain of 129%, assuming expiration with GOOG above $320.Similarly, the Oct $310/$320 bull put spread could be placed for a credit of $563 ($2058 – $1495) and a maximum potential gain of 129%, assuming expiration with GOOG above $320.Thus, if we were considering placing a bullish vertical spread on Google, the returns would be virtually identical whether the IV was 34% or 60%, or whether we used a credit or debit vertical spread. The higher IV value increased the individual option values dramatically, but the spread values were unchanged. Higher IV does result in higher option prices, but in a spread, we are both buying and selling that high value.I also computed these option values with IV adjusted to 20%. As we see below, at this very low IV, the returns for the credit and debit spread were still identical so there would be no advantage to placing the debit spread for this low IV stock as some have taught.The Oct $310/$320 bull call spread could be placed for a debit of $381 ($580 – $199) and a maximum potential gain of 162%, assuming expiration with GOOG above $320.Similarly, the Oct $310/$320 bull put spread could be placed for a credit of $623 ($1084 – $461) and a maximum potential gain of 165%, assuming expiration with GOOG above $320.However, the returns for both spreads at IV of 20% are higher than we saw with the other examples with volatilities of 34% and 60%. This is consistent with the overall financial laws of balancing risk and return, i.e., higher returns always carry higher risk. This example has us placing a bullish spread on a stock currently priced near the bottom edge of the price spread; the stock price must make a significant price move of over $9 before expiration for the spread to achieve maximum profitability. However, the low implied volatility tells us the probability of a significant price move is low. Therefore, the returns will be higher, commensurate with the lower probability of success, and therefore, a higher risk of loss.These examples illustrate two important conclusions:• The returns for a credit spread and a debit spread placed at the same strike prices for the same equity or index will be identical. Any price differences seen in the marketplace will be transient, as arbitrage will quickly bring the prices back to parity.• The level of implied volatility (IV) is not a consideration when placing a vertical spread and deciding on a credit or debit spread. High IV does increase the individual option prices, but we are both selling and buying option premium in a spread, so the returns for the credit and debit spreads remain identical.Changes in IV During the TradeThe maximum profitability of a vertical spread, once placed, cannot change due to changes in implied volatility after the trade was initiated. The initial investment and the width of the spread are fixed; therefore, the maximum potential return is fixed. This is equally true for both credit and debit vertical spreads. However, the time decay curves of the spreads are affected by changes in implied volatility. The value of the spread varies with time to expiration, implied volatility, and the price of the underlying stock. Of course, interest rates and dividends will also affect spread values, but these will be less significant effects. Experienced spread traders know that even though the underlying stock price may have moved as predicted above or below the spread strike prices, the spread cannot be closed for a value close to the maximum theoretical profit until close to expiration. The value of the spread will gradually approach the maximum profit as the time value of the options decays away.Increasing implied volatility (IV) during the trade results in the time decay curves being flattened so that the value of the spread approaches the ultimate value at expiration more slowly. Therefore, the probability of closing the trade early for a majority of the maximum profit is reduced. We won’t illustrate it here, but the flattening effect on the time decay curves due to increasing IV during the life of the trade is identical for credit and debit vertical spreads. Therefore, if one is expecting a large IV increase, such as in advance of an earnings announcement, there is no inherent advantage to either a credit or a debit spread. But one should expect to have to carry the trade closer to expiration to achieve a majority of the potential profit if IV increases.Vertical spreads have an inherent advantage over long or short option positions in that the ultimate profitability of the vertical spread is unaffected by IV changes while we are in the trade. By contrast, if we buy a call option in anticipation of a positive earnings announcement, we may be disappointed in the results. Most likely, IV will decrease dramatically following the announcement, and this will drive down the value of our call option. This negative effect may be of equal or greater magnitude than the positive effect on our call option due to the increased stock price.Decreasing implied volatility (IV) during a vertical spread trade results in the time decay curves spreading out so the value of the spread approaches the ultimate value at expiration more quickly. This effect on the time decay curves due to decreasing IV during the life of the trade is identical for credit and debit vertical spreads. The maximum profit available hasn’t changed, but the prospect of closing the trade early for a large portion of that maximum profit is now more probable.ConclusionsThe maxim to use credit spreads when implied volatility is high and debit spreads when implied volatility is low may be a confusion that arose out of long and short option positions. It is indeed true that one should consider buying low volatility options and selling high volatility options. If we are considering a long call or put position, we would look for options with low implied volatility because these are inexpensive options. And similarly, we would target high IV options if we were considering a short call or put position.However, when playing the stock’s directional move with a vertical spread strategy, the choice of a credit or debit spread is largely a personal preference. Some prefer a credit spread because they can earn interest on the credit monies in their accounts while in the trade; another advantage of credit spreads is fewer trading commissions (assuming the spread is allowed to expire worthless). Others prefer debit spreads because they have spent the maximum that can be lost on the trade; there is no possibility of an ugly surprise later if the trade turns against them (as there is for a credit spread). The returns for credit and debit spreads will be identical and IV levels will have no effect on the returns. The effect of the volatility (either high or low) effectively cancels itself out by the opposite nature of the two legs of the spread. Thus, vertical spreads are an excellent way to trade high volatility options when establishing a long or short option position would be both expensive and risky.The change of IV during the course of the vertical spread trade will shift the time decay curves. Decreased IV will make it easier to exit the spread early for a large portion of the maximum profit, while increased IV during the trade will make it more likely one will have to take the spread into expiration. But the ultimate profitability of the spread is unaffected by the change in implied volatility.