The determination of pricing as described above works in most
cases but please be aware that this assumes that the implied
volatility in both the 35 and 40 calls is the same. Most of the
time, these two options will have a slightly different implied
volatility.

This intra-month difference in implied volatility values through
different strikes is known as a vertical volatility skew. The
reason the markets run volatility skews is to make sure that
out-of-the-money options have enough premium in them to justify
the individual options risk/reward scenario. Volatility
skewness will be covered in more depth in the future releases
where we will cover the Option Pricing Model and the Greeks.

For now, it is enough to know that there is a volatility skew,
but as long as it is a tight skew (little deviation of implied
volatility from strike to strike) the values should hold pretty
consistent in our previous examples.

Whatever factors effect the vertical spread, they are contingent
on where the stock is in relation to the spread. Changes in
implied volatility affect the price of a spread as stated above
but the position of the stock in relation to the strikes of the
spread are a key determinate of price.

Volatility

To get a good feel for volatilitys effect on vertical spreads,
we will look at three different spreads, against three different
implied volatilities while keeping the stock price constant at
67 . The three spreads we will be looking at will be the 60
65 call spread, the 65- 70 call spread and the 70 75 call
spread.

Looking at the chart we observe how volatility movements affect
in-the-money, at-the-money and out-of-the-money vertical
spreads.

Looking at the in-the-money spread (June 60 65) we see that as
volatility increases, the value of the spread decreases. This is
because with the increased volatility, the stock will have a
greater tendency to move around and that will bring a higher
likelihood of the stock moving to a price where the June 60 65
call spread will no longer be in-the-money.

To adjust for higher volatility risk, the spread will have less
value. The rule of thumb is that as volatility increases, the
value of in-the-money vertical spreads decrease. Vice-versa, as
volatility decreases, an in-the-money vertical spreads value
increases.

The at-the-money vertical spread (June 65 70) will see very
little effect with the change in volatility. With the stock
price located equidistant from the two strikes, each strikes
volatility component will be very similar. Thus, when volatility
increases both options will increase equally. Being long one and
short the other, the increase in values will offset each other
so the spreads value will hold pretty constant. The rule of
thumb is that when volatility increases or decreases, the value
of an at-the-money vertical spread will stay reasonably
constant.

The out-of-the-money vertical spread (June 70 75) has the
opposite effect of the in-the-money vertical spread (June 60
65). As volatility increases, the value of the out-of-the-money
vertical spread will increase. This is because the increase in
volatility assumes that the stock price will be more likely to
move and thus the out-of-the-money vertical call spread will be
more likely to finish in-the-money.

Because of the increased potential of this spreads ability to
finish in-the-money, the value of the spread will increase.
However, if volatility decreases, the value of the spread will
decrease. The rule of thumb is that when volatility increases,
an out-of-the-money vertical spreads value increases. When
volatility decreases, the spreads value decreases.

Below, find a chart showing what happens to option deltas when
volatility increases or decreases.

When trying to estimate how your spread will change in price
with volatility movement, you must understand how the price and
delta of both of your options, (the long option and the short
option) will act.

It bears repeating again that each spread is different and will
act differently depending on where the stock is in relation to
the spread and what implied volatility does.

A good rule of thumb is that when volatility increases, spreads
crunch to their median value. For example, the median value of a
five dollar spread will be $2.50 while a $10.00 spread will have
a $5.00 median value. Crunching to the median value means that a
$5.00 spread that has a medium value over $2.50 will lose value
and head toward the median price. That happens with an increase
in volatility. Meanwhile, that increased implied volatility will
make a spread with a value less than $2.50 increase in value,
heading up toward median value. When implied volatility
decreases, the value of a $5.00 spread will move away from the
median price of $2.50. So, when implied volatility decreases,
all the spreads valued above $2.50 will increase in value toward
maximum value, while spreads valued below $2.50 will lose value
and head toward $0.

Time effects the spread differently depending on where the stock
is. As an example, we will look at the QCOM 65 70 call spread.
We view the spread over time and across three different stock
prices. First, lets look at the spreads reaction to the
passing of time with the stock price of $65.50. Below, find a
chart showing what the spreads value does as expiration
approaches.

With the stock at $65.50, the spread has $.50 of intrinsic
value. Holding the stock price frozen at $65.50 until expiration
the spread would be worth $.50. As seen by the table above, the
spread loses value as time passes and decreases in value toward
its $.50 intrinsic value.

Next, we will look at the 65 70 spreads reaction to the
passage of time with the stock priced at $67.50.

As you can see, with the stock price located directly in between
the two strikes, the price of the spread holds at approximately
$2.50 throughout the passing of time. As a rule of thumb, time
has very little effect on a vertical spread when the stock price
lies half-way (equidistant) between the two strikes of the
spread.

Now, we set the stock price at $69.50 and observe how the spread
reacts over time.

The chart shows that as time passes, this spread increases in
value. With the stock at $69.50, the spread has an intrinsic
value of $4.50. If the stock held at $69.50 until expiration,
the spread would be worth $4.50 because that is the amount of
intrinsic value the spread has. As time passes, the spreads
value will increase to finally reach $4.50 at expiration.

In conclusion, times effect on a vertical spread is contingent
on where the stock is in relation to the spread.