Documenting spread and combination trading in a major options market for the first time, we find that spreads and combinations collectively account for over 55% of large trades (trades of 100 contracts or more) in the Eurodollar options market and almost 75% of the trading volume due to large trades. In terms of total volume, the four most heavily traded combinations are (in order): straddles, ratio spreads, vertical spreads, and strangles. These four represent about two thirds of all combination trades. On the other hand, condors, horizontal spreads, guts, iron flys , box spreads, guts, covered calls or puts, and synthetics are very rarely traded while trading is light in collars, diagonal spreads, butterflies, straddle spreads, seagulls, doubles, and delta-neutral combinations. Significant differences in size, cost, and time-to-expirations are found among the various combination types. Our results confirm that traders use spreads and combinations to construct portfolios which are highly sensitive to some risk factors and much less sensitive to other risk factors. The most popular combination designs are those yielding portfolios which are quite sensitive to volatility and less sensitive to directional changes in the underlying asset value-though they are often not completely delta neutral. Among these, combinations which are short volatility significantly outnumber those which were long. Among the minority of combinations which are highly sensitive to the underlying asset price, those with positive deltas significantly outnumber those with negative deltas indicating that traders are using this market to bet on or hedge against an increase in the LIBOR rate. We find evidence that effective bid/ask spreads are larger on orders exceeding 500 contracts or more than on orders of between 100 and 500 contracts and evidence that effective bid/ask spreads are larger on combinations which short volatility. Option Spread and Combination Trading I. Introduction By creating a trading portfolio with heightened sensitivity to one or more of the determinants of option prices and reduced sensitivity to others, option spreads and combinations, such as straddles, strangles, bull and bear spreads, and butterflies enable traders to exploit expected changes in either the price of the underlying asset, its volatility, and/or the time to expiration while minimizing their exposure to the other risks. Consequently, virtually every options and derivatives text devotes at least a chapter to these spreads and combinations and they are the subject of much of the print and electronic materials distributed by option exchanges and the options industry. Despite the attention spreads and combinations receive in derivatives texts and industry materials, they have been largely ignored by researchers. To date no one has documented which, if any, of these trading strategies are actually employed and, if so, how often. Using a unique database for one of the most active options markets, that for Options on Eurodollar Futures, we fill this gap by docum...

Despite the fact that they are heavily traded, discussed in every derivatives text, and necessary to aligning implied volatilities with volatility expectations, volatility trades such as straddles, strangles, and option/asset combinations have received scant attention in the finance research literature. Using a unique data set for the Eurodollar options market, the trading and structure of seven volatility trades-straddles, strangles, option/asset combinations, guts, butterflies, iron butterflies, and condors-are examined. We find that both traders' choices among the seven strategies and the designs they choose for the individual strategies indicate that volatility traders seek designs with (1) low deltas, (2) low transaction costs, and (3) high gammas and vegas. Among other things, these three presumed objectives explain why butterflies, guts, and condors are rarely traded; covered call and put writing is rare; and straddles are the most popular volatility trade. These objectives also explain the usual design of straddles, strangles, and asset/option combinations and the straddle-strangle choice. Our data also indicate that, in constructing their spreads, traders rely on Much of this research was completed while Ederington was Visiting Professor of Finance at the University of Otago and at Singapore Management University, whose support of this research is appreciated. We have benefited from the comments of an anonymous referee, Christine Brown, Timothy Crack, and participants in finance workshops at

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Documenting spread and combination trading in a major options market for the first time, we find that spreads and combinations collectively account for over 55% of large trades (trades of 100 contracts or more) in the Eurodollar options market and almost 75% of the trading volume due to large trades. In terms of total volume, the four most heavily traded combinations are (in order): straddles, ratio spreads, vertical spreads, and strangles. These four represent about two thirds of all combination trades. On the other hand, condors, horizontal spreads, guts, iron flys , box spreads, guts, covered calls or puts, and synthetics are very rarely traded while trading is light in collars, diagonal spreads, butterflies, straddle spreads, seagulls, doubles, and delta-neutral combinations. Significant differences in size, cost, and time-to-expirations are found among the various combination types.Our results confirm that traders use spreads and combinations to construct portfolios which are highly sensitive to some risk factors and much less sensitive to other risk factors.The most popular combination designs are those yielding portfolios which are quite sensitive to volatility and less sensitive to directional changes in the underlying asset value -though they are often not completely delta neutral. Among these, combinations which are short volatility significantly out-number those which were long. Among the minority of combinations which are highly sensitive to the underlying asset price, those with positive deltas significantly outnumber those with negative deltas indicating that traders are using this market to bet on or hedge against an increase in the LIBOR rate.We find evidence that effective bid/ask spreads are larger on orders exceeding 500 contracts or more than on orders of between 100 and 500 contracts and evidence that effective bid/ask spreads are larger on combinations which short volatility.

a r t i c l e i n a n y f o r m a t 28 VERTICAL SPREAD DESIGN SPRING 2005Data on options on eurodollar futures allow examination of the design and trading of vertical spreads, also called bull and bear spreads. The objective of reducing cost or increasing profit likelihood of long positions appears more important than risk reduction on short positions in the decisions to use vertical spreads instead of single options. There is little evidence that vertical spreads are designed so as to minimize vega risk, maximize absolute deltas, or engineer positive gammas or negative thetas. There is also no evidence that the shape of the smile impacts spread design. Strong trader preference for out-of-the-money strikes on debit spreads is consistent with a hypothesis that debit spread traders seek either moderately low prices or high values of delta per dollar at risk, but reasons for the slight preference for out-of-the-money strikes on credit spreads are unclear. When futures are combined with a vertical spread position, it is almost always in a ratio that reduces the position's net delta to zero, turning the spread into a volatility trade. Seagulls, where a third option adds a tail to the vertical spread in the same direction, represent a fairly actively traded but rarely discussed variant of the standard vertical spread design. They have lower prices and higher deltas than bull and bear spreads.V ertical spreads (bull and bear spreads) are a popular options trading strategy. In the eurodollar futures options market, they represent about 9.4% of all option trades of 100 contracts or more and account for about 11.6% of the trading volume (Chaput and Ederington [2003]). The basic characteristics of vertical spreads are discussed in every derivatives text and in the practitioner literature, such as McMillan [1980], but to our knowledge no researcher has examined their design and trading in any depth. No one has asked how vertical spreads should be designed theoretically, and no one has examined how they are structured in practice.We seek to fill this void by examining the design and trading of vertical spreads and their closely related cousins, seagulls (where a third option adds a tail to the vertical spread in the same direction) in the eurodollar futures options market.The basic mechanics of vertical spreads are well known. A bull call spread is created by buying a call option at one strike, X 1 , and selling a call with the same expiration date at a higher strike, X 2 .The profits to this strategy, when held to expiration, as a function of the underlying asset price are illustrated in Exhibit 1, Panel A, where the profits on the two individual options are shown as x-ed or dashed lines and the spread as the solid line. As compared with simply buying call option X 1 , the bull spread buyer gives up the additional profits if the underlying asset price rises beyond X 2 , but also lowers the cost of the spread and therefore curtails losses if the underlying asset price does not rise as anticipated.