Creating A Vertical Spread Index

October 29, 2012


Most investors are familiar with options as powerful hedging tools suitable for protecting equity or exchange-traded fund positions. Others have explored options further by enhancing their positions through call and put writing. Regardless of the approach, another attribute of options is that they allow investors to benefit from the power of leverage, providing notional exposure to an underlying for a fraction of the actual cost.

Before fully exploring the dynamics of this exposure, let us review some important elements of options trading. A common misconception is that the price change, known as delta, of a call relative to the underlying stock happens at a 1-1 ratio (delta = 1) for all underlying prices above the call’s strike. This is only the case very near to or at expiration or at strike prices at or further out than expected volatility. The reality is that with more time to expiration, underlying prices have a greater chance of deviating from their current price levels. Accordingly, the delta of the at-the-money (ATM) contract is 0.5 (a 0.5-1 ratio price move as compared with the underlying) and why any ATM trade is also referred to as the "50 delta trade." At a high level, the combination of the option contract moving deeper in the money and closer to expiration comes together to raise the contract’s delta toward 1. Consider Figures 1 and 2 (data provided as of authoring of article).



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