On the one hand, it seems like a good time to be an option buyer: limited risk, leveraged reward, etc. But on the other hand, they’re just so darn expensive! Right now implied volatility is at historic highs. That means, when you’re buying a call or a put for a directional bet, you’re paying up because of volatility.
One way to combat high implied volatility is to trade a spread. A spread involves buying one option and selling another. Rationale? While you’re buying an expensive option, you’re also selling an expensive one, too. That means it’s possible to net out some of the potentially adverse effects of high implied volatility.
In terms of greeks, with spread trading all the greeks are lower. But vega is usually much more reduced than delta. That means there is still a fair amount of the wanted directional sensitivity without as much implied vol risk.
There are a couple of tricks to this technique. First, it should go without saying, that since this is a directional play, you have to be right on direction to make money. But what’s important in setting up the trade is strike selection–especially on the short strike. The short strike should coincide with the price point in the underlying conducive with expectations. That is, sell the strike that is as high (low) as you think the stock will go.
A trader thinks XYZ stock will go from 50 to 60 over the next month but wants to hedge implied volatility risk. He’d buy 1 30-day, 50-strike call and sell one 30-day, 60-strike call. This is what traders call a bull call spread, or a debit call spread. Here the trader retains a lot of the directional sensitivity (delta) but spreads off most of the implied volatility risk (vega). If he’s right and the stock goes to 60 in 30 days, he reaches his maximum profit (in this case $10 minus the cost of the spread). If the stock exceeds $60 a share, though, profits are limited. If, however, the stock falls, the trader can lose up to the amount paid for the spread.
In times like these, where volatility rules the market, traders need to trade smart and use everything they can to gain as much edge as possible. Spreading off volatility risk is one technique that all traders should consider.