Vertical spreads are a smaller trade than naked positions and the narrower the spread the lower the buying power requirement. New traders may be misled by the lower buying power of tight vertical spreads relating to lower risk, but when comparing these differently sized trades, it’s important to normalize by this buying power amount. One way to compare these trades is to look at the return on capital.The Study:
- 2005 – Present
- 45 Days to Expiration
- 30 Delta Short Option Spreads Varying Widths:
- 1, 5, 10 Wide
- Compared Return on Capital Volatility
Even though tighter spreads appear to have less risk because of their lower buying power requirement, when comparing the return on capital volatility of varying width spreads we see that the wider the spread, the lower the return on capital volatility. Another way to reduce this volatility is to manage the trade at 21 days. When managing at 21 days the return on capital volatility is reduced by roughly 50% for all width spreads.