Options Trading Mastery: Time Decay and Volatility Trading Opportunities (3)

By selecting an at-the-money option to sell as part of a vertical spread, an investor can execute a time decay play with a hedged position.


Much in the same way that a vertical spread can be used as a time decay play, it can be used as a volatility play.


We stated earlier that an at-the-money option has more extrinsic value than any other option in its expiration month.


This is due to a number of contributing factors including time but it is in no small way due to volatility.


Volatility is a huge component of an option's extrinsic value.


An option's dollar sensitivity to movements in implied volatility is known as vega.


Obviously, an at-the-money option will have a higher vega (volatility sensitivity) then will an in-the-money or out-of-the-money option in the same month.


As volatility increases, the at-the-money option will increase in price to a greater degree than will an in-the-money or out-of-the-money option in the same month.


As volatility increases, the at-the-money option will increase in price to a greater degree then will an in-the-money or out-of-the-money option whose vega's will be less.


Conversely, the at-the-money option will lose value at a greater rate than an in-the-money or out-of-the-money option should implied volatility decrease.


The question now is how to use the vertical spread to take advantage of anticipated movements in implied volatility.


Remember, the vertical spread affords you the luxury of being hedged on either side of the trade - both as a buyer and a seller of the spread.