One of the most interesting and challenging parts of options spreads is the ability to put together positions that utilize completely different options to achieve the same or similar objective.
One excellent example is the vertical bull call spread, which is a debit spread, and the vertical bull put spread, which is a credit spread. Both spreads profit from rising markets and both spreads are vertical spreads.
This begs the question: When is the best time to initiate a debit spread in comparison to a credit spread?
If you take a look at the IBM chart below, you can see a developing ascending triangle breakout. The stock’s daily range was winding up for some time and it looks like it may be a good candidate for a long trade.
If I believed that this trend is going to continue moving in the same direction over the next few weeks, I could either initiate an out of the money call debit spread, limiting my profit to the difference between the strike price that I purchased and sold.
Or alternatively, I could just as simply initiate a put credit spread, allowing me to sell a put close to the money and collect the premium, while at the same time purchasing a cheaper put, so that if the stock moves lower, I will be protected to the downside by the hedge created by the cheaper strike price put option that I own.
The key to figuring out whether we want to trade bull call spreads or bull put spreads is largely determined by the implied volatility levels in the underlying asset at the time we anticipate initiating the trade.
The only way to determine whether implied volatility is currently on the high end or on the low end is to look at the past implied volatility levels and compare them to the current levels.
You should also keep in mind that implied volatility levels can only be compared to past implied volatility levels using the same underlying asset — comparing implied volatility levels from one asset against a different one will not help you determine if current levels are high or low in comparison to the past.
IBM’s implied volatility level has fluctuated between .20 and .35 on average over the past half year and prior to that time as well. Currently, the implied volatility levels are at the highest levels, telling us that implied volatility levels are on the very high end of the range at this time — and that means IBM calls as well as puts are overpriced at this time.
When options are overpriced, the odds greatly favor the options seller; which tells us that we should be selling options instead of buying them. Out of the two bull spreads, the bull put spread is the one that benefits the option seller, because the seller receives the premium upfront for selling the option and that option is expensive in relationship to past value.
If implied volatility levels were lower, near the .20 or even slightly higher, implied volatility levels would be on the lower end of the range. In that case, I would recommend utilizing strategies that involve the buy side instead of the sell side. That means initiating bull call spreads instead of bull put spreads.
Because bull call spreads involve buying the expensive call and selling the cheaper one, lower implied volatility levels help keep the price of the call that you are buying lower in comparison to historic value, making it ideal for buyers instead of sellers.
In conclusion, when implied volatility levels are high in comparison to past levels, you want to leverage options spreads that favor the seller, because options will be overpriced and that’s the best time for selling premium.
Conversely, at times when implied volatility levels on the underlying asset are low, you want to leverage options spreads that favor the buyer.
The two vertical spreads, the bull call spread and the bull put spread, both take advantage of rising prices, but at the same time, implied volatility should dictate which side of the market you should be on at any given time, regardless of the underlying asset’s current direction bias.
Roger Scott is a retired hedge fund manager and expert trader with over two decades of experience in financial markets. Between 1999 and 2009 he generated multi-million dollar returns for banks, financial institutions and ultra-wealthy clients. For the past 10 years, Roger has been educating and helping everyday people around the world become consistently successful traders.