Option spread trades: Returns on directional and volatility trades oa

Option spread trades can be set up in a variety of different ways and offer flexibility for an investor to target specific goals in terms of risk-return profile. I study different setups of Bull spread trades with Calls to illustrate which setups are largely directional trades and which setups are largely volatility trades. Analytical derivations reveal that setups involving short positions in out-the-money Calls offer the strongest directional plays, whereas other setups are mostly long or short volatility. An analysis of spread returns using S&P 500 Index options data reveals high average returns, strong negative skewness in short volatility setups, and positive skewness in long volatility setups. Returns are heavily affected by costs of trading, but setups including short positions in out-the-money Calls return strong average returns even after costs. Factor analysis reveals that positive alpha is more readily obtained for trades held until maturity rather than for trades closed out before maturity. © 2016 Macmillan Publishers Ltd.