A Back Spreader’s Nightmare

Definition:  Back spreads are positions in which more
options are bought than sold.  The options expire in the same month and the investor has unlimited upside and/or
downside profit potential. 

But there's always an expiration range on the
underlying asset (the sour spot??) that makes owning such positions painful.  That price range is near the strike price of the options you own.  If those expire worthless (or almost worthless) while the options you sold are nicely ITM, the result is a good sized loss.

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I was disciplined this month.  I adjusted when necessary, I have plenty of protection if the market continues to rally.  My downside is good.  In fact, my risk graphs are all smiles.

Smile

 Sample 'smile graph'

But that does not tell the whole story.  With RUT currently trading @ 531, I'm short the RUT Jun 530/540 call spread.  Under normal circumstances, and following my risk management style, I would have already exited that spread. 

But this time I have a great deal of extra protection.  I own extra Jun 540 calls.  I also own extra July calls.  Although those longs were bought to protect other call spreads that I sold, these extra options represent a significant upside opportunity.  This is one time that owning pre-insurance has paid off.  Let me restate that:  It's currently doing it's job nicely, but there's risk that the position can collapse.

The problem is that there are only two weeks remaining before the June options expire and it's crunch time.  I must decide whether to hold onto the Jun 540 calls – with their wonderful positive gamma and their not-so-wonderful negative theta.  Or I can replace them in my portfolio with July calls. 

If I sell the extra Jun 540s, holding the Jun 530/540 becomes iffy.  The good news is that I will lose most of that large negative theta.  The bad news is that I'll lose the near-term gamma that produces big profits (to more than offset losses) if the index moves much higher (quickly). 

If I buy July or August calls when I sell the Jun 540s, I'll gain a bunch of vega.  That would not ordinarily be a problem because iron condor traders are usually short vega.  But I've been trading flat vega as the market has risen, and this doesn't feel like the right time to get long too much vega.  There are, of course, steps I can take to sell vega (buy iron condors), but I don't want to add much more to my portfolio prior to June expiration.  Owning too much vega can be a problem.

If this Jun spread were my only position, I would not hold it.  However, it's just one part of a larger portfolio, and much of the risk is covered.  But it makes me very nervous and it's always tempting to sell those near-term, soon-to-be ATM calls, and replace them with a larger quantity of further OTM calls.  That's adding a diagonal back spread to the portfolio. 

Is this going to turn out to be a back spreader's nightmare – or a dream come true?

P.S.  If the market declines, this problem disappears.  I'm not holding my breath.

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