One must have heard or read the following thumb rule for options spread trading, ?When implied volatility is high, sell credit spreads and when it is low, buy debit spreads.?

Unfortunately, this is simply not true. The credit spread and its corresponding debit spread at the same strike prices will always have virtually identical returns on investment (ROI). I have tried to explain the role of implied volatility in the vertical spread (spread trades using two options at two different strike prices in the same expiration month) with the help of an example, both at initiation and over the course of the trade in a two-part article.

Company ABC say for example closed at Rs 310 on January 5. If one were bullish on this stock, one could place an January 310 – 320 bull call spread for a debit of say Rs 430 (960 – 530) and a maximum potential gain of 133%, assuming expiration with ABC trading above Rs 320.

Similarly, one could place a January 310 – 320 bull put spread for a credit of say Rs 560 (1,400 – 840) and a maximum potential gain of 127%, assuming expiration with ABC above Rs 320.

The small difference between the two returns is insignificant. The conclusion is that any difference in returns between a credit and debit spread for the same underlying stock, strike prices, and expiration month will be small and temporary, because market forces (read arbitrage opportunities) will quickly adjust them to parity.

It is commonly taught that one should establish a credit spread when placing a trade with high implied volatility (IV) options and a debit spread with low IV options. But (the actual IV values in the above example ranged from 33% to 34%).

If we assume the IV?s to increase dramatically, all it would do is increase the value (read premium) of the option, but since we are entering into a spread trade, the net spread would ultimate balance out, thus netting out the effect.

The maximum profitability of a vertical spread, once placed, cannot change due to changes in implied volatility after the trade was initiated. The initial investment and the width of the spread are fixed; therefore, the maximum potential return is fixed. This is equally true for both credit and debit vertical spreads.

To be continued

The writer is a derivatives analyst