Many investment newsletters and option strategy resources tout put-spreads and call-spreads as the two fundamental option strategies. In doing so, they often tell retail investors to do exactly the wrong thing. In a world of flat volatility curves, I do not care what you buy and sell in the option arena. Unfortunately, volatility curves are anything but flat and it makes a very big difference if you pay attention to the curves.
When selling naked options to earn premium many investors are very scared of the unlimited risk. If you sell a call option at a strike of $50 the stock could theoretically go to infinity before expiration. When selling a put option with a strike of $50, the stock could theoretically go to zero and you would lose $50. The strategy that many option experts suggest is to sell a spread. Instead of just selling a put at $50, you also buy a put at $45 or $40. That way you can not lose more than the gap between the two strikes. If you sold a $50-$45 put spread you are only on the hook for paying out $5 because for every point below $45 you make an offsetting dollar on the put that you purchased. This is sold to retail investors as a way to mitigate risk and get rid of the possibility of large losses.
In following this recommendation, many retail investors are doing exactly the opposite of what I would like to see them do. In general, equity options exhibit a smirk, or negative skew. This means that options at lower strikes have higher implied volatilities than options at higher strikes.
Options with lower strikes have higher implied volatility
What this means for the put spread seller is that he is buying an option at a higher implied volatility than the option that he sold. In every post about options I always emphasize that you want to sell at high implied volatility and buy at low implied volatility. If the strategy forces you to do the opposite, then you should reassess your strategy.
In order to make this post complete, I will list the spread strategies that make sense given the shape of the implied volatility curve in the market that you are trading.
Now think of how you would trade ratio spreads using this same methodology…
