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As I understand it, increasing the width between strike prices in a vertical spread increases your risk/reward. Alternatively, you could just buy a greater number of contracts with a small width between strike prices. What are the practical differences and pros and cons of these two approaches?

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One practical answer is that if you make the spread too narrow you are essentially turning your spread into a binary outcome. If you buy a call-spread $1 apart out of the money lets say you are risking 0.30 to win 0.70. Since the spread is so narrow it will normally either win 100% or lose 100%.

Compare that with a spread where you are buying the ATM call and selling the same OOM call, You are paying more premium but you have a smoother return as the price rises, even if the underlying price does not reach all the way to your sold call you can still profit.

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I could give you a detailed explanation of the non linear aspect of option pricing and how it affects the risk/reward of each spread. I could also add the effect of skew if it exists, demonstrating the analytical reasons for the "practical differences and pros and cons of these two approaches." But what would be the point of telling you how to build a clock when all you want is to know the time? So here's how to tell time :-)

For a credit vertical, the reward is the premium received and the risk is the difference in strikes less the premium received.

For a debit vertical, the risk is the premium paid and the difference in strikes less the premium received is the reward.

Set up a spreadsheet. One column for the wider spread. Another for the narrower spread. Multiply one of these columns by your spread ratio (more spreads versus fewer spread). Set up the strikes of your verticals and populate it with the respective bid and ask prices. Set up columns to calculate risk and reward. No complicated theoretical explanations. No mental effort at all. No building a clock. Just dropping the quotes into your spreadsheet.

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  • actually, i'd love to hear you provide the more detailed explanation if you're willing – Ashish Mar 31 at 2:24
  • This is one of those things that you really have to do for yourself to see the relationships. For a gross analysis, look at a liquid option chain during market hours (narrow B/A spread) and compare the various spreads. That will demonstrate the premium to spread width relationship. Compare the results of these same options plugged into an option pricing model (skew). This is an academic exercise that doesn't have much bearing on reality. If you trade options long enough you get a feel for pricing behavior. – Bob Baerker Mar 31 at 3:03

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