V.8:6 (230-233): Speculating in vertical spreads by Bradley J. Horn

Speculating in vertical spreads by Bradley J. Horn

Many gasoline traders are familiar with the fundamentals of spread trading with New York Mercantile Exchange (NYMEX) energy futures. Far fewer, however, are able to recognize opportunities in option spreads, for good reason: The trader entering an options market for the first time may find himself subject to "contract shock," for unlike the futures trader, whose spread choices are limited to 15 contracts, the options trader must deal with a bewildering assortment of contracts, each with its own price dynamics.

Spread traders will find that the limited risk and flexibility in options trading can be more responsive to their needs than only trading in futures. The innovative traders and risk managers can use spreads by utilizing gasoline options to achieve attractive returns and hedge protection at low cost. At the same time, an options spread can be used to reflect different expectations through varying market conditions, thereby enabling traders to fine tune their market response. One strategy that provides such flexibility is known as the vertical spread.

A vertical spread consists of one long option and one short option, where both legs of the spread are of the same type (that is, both calls or both puts) and expire simultaneously. Each leg differs only by the strike price of the individual option.