Call Spreads: Strike Selection and Trade Parameters


I've been wondering what the trade-offs are when one sweeps (for analysis) a simple call spread from FITM, ITM, ATM, OTM, FOTM.

Yes, there's the risk/reward vs. probability trade-off.  But it seems like there may be more trade-offs to consider, such as impact on vega, initial delta/gamma vs near expiration delta gamma, initial vs. later theta, and perhaps even risk/reward : probability ratio may change as one sweeps across the scenarios.

I've been thinking that the best risk/reward vs. probability ratio is probably when one sells the ATM option because it will always have the most time premium and hence selling the more time premium than one is buying in a spread would yield the highest risk/reward vs probability ratio.

[Dave, I don't know what you are saying here.  If you buy a very FOTM  call spread, the probability is almost zero, and that gives the highest possible ratio.  Moving that denominator towards zero increases the ratio far more than increasing the numerator.]

But, it's not clear to me if that's the case or if some of the other considerations neutralize that edge.  Hence, wondering what are the various trade-offs as we analyze a spread at these different strike positions.




There are plenty of items to consider, and yes, there are trade-offs.  My question is: Does any of it matter?  When choosing to buy a call spread (or put spread), the two vital factors are the trader's outlook for the underlying and the trader's 'style.'

Dave, if you prefer to buy the higher probability, lower profit potential ITM call spread – what factors could convince you to own OTM call spreads instead?  Does theta or the ratio of some Greeks change your outlook?  When you buy a call spread, it seems to be you are bullish.  But that does not mean that all bullish plays are reasonable.  It's one thing to buy an IBM 110/120 call spread when IBM is 121, but buying the 150/160 call spread is also bullish play, but foolish.

The spreads you prefer to trade describe your style.  I know that I would never buy OTM call spreads as a bullish play.  The low probability of success does not fit within my comfort zone boundaries.  And there are plenty of traders who would not want to own ITM call spreads, but those are the only ones I elect to buy (by selling the corresponding put spread, which is the equivalent position).

If I had
mathematical proof that
trading near ATM iron condors improved long-term results by enough of a
factor to make it worthwhile, I'd still find it uncomfortable to trade
that way. 
I'd feel the constant need to make adjustments – despite the fact the
'evidence' telling me that such adjustments are not needed.  Remember, that the human trader must handle the trade.  When uncomfortable or uncertain, how is that trader going to skillfully manage risk?

I agree.  There are trade-offs. However, in the specific strategy that you chose, I believe all such trade-offs are are less important than the fact that a call spread buyer must be right on direction, timing, and sometimes – the size of the move.  The effect of theta or the concern about near-expiration gamma cannot make me prefer a different style of call spread.

factors are difficult to overcome.  Can you
take mathematical evidence and convince yourself to ignore discomfort when trading the position?  I cannot.  When trading without the ability to adjust as I think best, then the trader has a set it and forget it' mentality.  That may work for some, but I don't recommend it.'

Don't misunderstand.  There are many situations in which I take advantage of edge – when I find it.  But the idea of moving towards buying OTM spreads is (currently) outside the range of possibility for my style.

I'll take the
smaller reward that comes with feeling good about my trades.  Over the years, I've had
enough sleepless nights to last a lifetime.  I must own a
portfolio that I believe is likely to produce profits.  That portfolio must satisfy my psychological need to not suffer.  Owning nonadjustable positions does not work for me.  Does it work for you?
  There's only one person who can answer that question.

Here is another problem:  Do you know what you want to find by asking these questions? 
For example, can you quantify how much vega risk you would accept to
generate a better delta/gamma ratio?  As you sweep across the strikes
and find changes in the Greeks and Greek ratios – would you know the
'best combination' if you see it?  I wouldn't,  The point in gathering data is to find evidence to prove or disprove a theory.

Agree.  ATM spreads offer the best theta.  That's good if negative gamma is of no concern.


For the true scientific trader, finding an edge to exploit is Nirvana, and that edge should be exploited.  That leaves trading and trade decisions to the computers.  That's not for me.

I admit to being a 'keep
it simple' trader.  Deeper analysis may provide more edge and
that, in turn, leads to better results.  But it does change the rules of the game.

Cheers to
you.  I'd like to offer a more scientific reply, but it's beyond me.


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2 Responses to Call Spreads: Strike Selection and Trade Parameters

  1. Josh 07/06/2010 at 10:22 AM #

    There’s a lot of academic research that shows that OTM options (and especially FOTM) have a statistically significant negative expected return, which of course means a positive return for sellers. One paper calculates the implied odds of a 1987 crash based on average OTM S&P 500 puts. They claim we’d have to experience Black Monday about every 1.5 years for OTM put buyers to break even.
    Great resource on option research is here:

  2. Mark Wolfinger 07/06/2010 at 11:30 AM #

    CXO runs a good site. Most of their discussions are very specific and not of interest to a general audience.
    However, they will research topics per reader request and subscribing to their RSS feed allows you to see their frequent posts.
    Thanks for sharing.