Vertical Spread Design

Abstract

Spread trades represent about 10% of total activity in the market for large eurodollar futures options trades. The practitioner literature offers a variety of reasons for spread trading, but which of them are the most important to traders? Are they taking speculative long positions in one option and then selling off some of the upside potential to reduce cost and increase leverage? Are they taking speculative short options positions but then buying protection on the downside to limit the loss in case they are wrong? Are they spreading primarily to manage overall position gamma or vega? What about spreads with an additional position in the underlying futures contract, or in a third option (a “seagull”)? In this article, Chaput and Ederington provide answers to these questions and a number of others, based on their analysis of a unique data set gathered at the Chicago Mercantile Exchange.