Back Spreads. Standard and Diagonal

The market has been surging recently.  One way to participate is to be long.  Buy calls or call spreads, sell puts or put spreads etc.  But for those of us who (stubbornly) are not willing to do that, is there an alternative investment that provides an opportunity to make some money if the market continues to rise – but which is protected from loss if the market turns around and declines as rapidly as it rose?

Yes, there is.  A back spread is a position in which you begin by selling a call (or put) spread, and buy extra options.  In this example, we're looking to win on a continued rally, so we use calls.  It's those extras that give you an upside profit potential.  For example, instead of selling an XYZ May 90/100 call spread, you might decide to make this position delta neutral.

Back Spread Example:

Sell 10 XYZ May 90 calls
Buy 15 XYZ May 100 calls

Depending on the price of these options, which in turn depends on the implied volatility (IV), you can probably collect a cash credit when opening the position. [And you may want to buy more than 15, depending on the option's delta].

The good news about this spread is that it has an unlimited upside gain.  If the stock rallies far enough those 5 extra calls will pay off.

Unfortunately, this spread carries significant risk due to its negative theta.  If too much time passes, your long options will not increase in value fast enough to offset time decay, and you lose money.  If expiration approaches, and XYZ is trading near 100, there's the possibility that your long calls become worthless and the short calls can be worth about $1,000 apiece.  Not a pretty result.

That's the problem with a back spread.  If the market tumbles, you will be glad you didn't own calls because they would lose their value in a hurry.  If you have the back spread, and if you collect cash when opening the position, they you can earn a small profit (the credit) on the decline.  Back spreads are difficult for individual investors to manage, but are excellent insurance against a huge upside move for market makers and other traders with large positions.

So if it's not so good for you, the individual, why am I discussing this trade?  The answer is that this is similar to a spread can work out better – especially when you intend to own the position for more than a few days.  It's the diagonal back spread.  It has its own set of risks, and we'll look into those.

I've written about the diagonal spread before, but those positions consist of buying one call for every call sold.  The diagonal back spread involves owning extra calls.

I'll go into further detail next time and provide some risk graphs to illustrate how this position can work.

to be continued..



11 Responses to Back Spreads. Standard and Diagonal

  1. dave appel 03/27/2009 at 8:09 AM #

    Hi Mark,
    Awhile ago I traded ratios which was tough because it was in 2006 toward the end and the naked options on the ratio spread stung me. I have never traded a backspread though due to the negative theta mentioned. A question on this. What do you look for in terms of delta and gama from the position when you open it ? I ask because it would seem you really need to have the right gama and delta to make this work. Not enough of a move or enough of the long options in the back strikes could make this a flop. Yet it appears if the structure was correct especially if you collected a credit on this it could be an excellent position to own in a market moving sharply. As always thanks for the great blog !

  2. Mark Wolfinger 03/27/2009 at 8:30 AM #

    Mark Wolfinger said…
    Thanks for appreciating what we do!
    As you know, back spreads are difficult for investors because of the negative theta. I did NOT write about this topic to encourage anyone to try to trade back spreads. Yes, they do work very well when the market makes a very large move. Otherwise it’s a difficult position to manage. The pros who adopt back spreads neutralize delta frequently – hoping to profit from up and down moves. But, I do NOT recommend this strategy for you.
    The purpose of this post is for it to be an introduction to the idea of diagonal back spreads. I merely used standard back spreads as an introduction.
    Have a bit of patience and read about those diagonals before deciding whether to use standard back spreads.

  3. dave appel 03/27/2009 at 8:47 AM #

    thanks Mark,
    And I will review the back spreads and diagnols. But Are you looking to open the back spread at delta neutral ?

  4. Mark Wolfinger 03/27/2009 at 8:56 AM #

    Yes, delta neutral.
    When dealing with stocks, there is often a scarcity of strikes from which to choose.
    But, with indexes, you can establish pretty much whatever appeals to you. For example, with RUT near 440, you can own anything from 450 to 500s. When selecting a long to buy – you can control the gamma, theta etc.
    But you must be practical. If a FOTM call looks good on delta, gamma, theta etc, you must remember that that call is going to go to zero quickly and will not ofer the protection you think you have.
    This is a good spread for paper trading. There’s lots to learn by observing. But, because you are familiar with ratio spreads (front-spreads), the opposite of back spreads, that experience may be helpful.

  5. dave appel 03/27/2009 at 9:05 AM #

    Thanks. i have known about back spreads for awhile but opted out due to theta. And I would be using the spy for this. I will paper trade it before I begin in real life though.

  6. Hello,
    I just came across your blog. I wanted some opinions/comments coverage on butterfly spread. I use stocks more than indexes. An example, my projection is FAZ will be @ 25 on Apr 17, 09, If I put on a 30/25/20 butterfly puts at a cost of 0.50, ie, buy one 30 sell two 25’s and buy one 20.
    Is this too risky to get assigned prior to expiration? I looked at it as 0.5 (cost) to make 5 minus commish off course. What other risk I have overlooked?
    Nam Al

  7. Mark Wolfinger 03/27/2009 at 11:10 AM #

    Welcome to the blog.
    1) There is always risk of early assignment, but when trading FAZ that risk is essentially zero.
    When someone exercises a put, that’s equivalent to selling the put and selling stock. In turn, that’s equivalent to selling a call at a premium of zero. Because FAZ options carry a very high implied volatility (IV), no one in his/her right mind would exercise early.
    And if someone does exercise, it’s no big deal. Just sell FAZ shares and sell that same put again. It’s very likely those puts will carry time premium – due to high IV.
    2) True you may turn 50 cents into $5, but do you really anticipate that FAZ will be 25.00? If not, then profit potential is less.
    When you own a butterfly, it necessary to hold the position until expiration is near – if you want to collect anything near the maximum. Again, it’s the implied volatility that prevents the butterfly from approaching parity (no time premium in any of the options) until the end of trading on expiration day.
    Being forced to hold to the end is definitely a risk. Of course, if you would be willing to sell the position at a much smaller profit before expiration, then this risk disappears. But, so does the potential high reward.
    3) Risky? Paying 50 cents for a 5-point butterfly in a very volatile stock or ETF seems to be a fairly high price to me. But that’s obviously a personal decision.
    4) Are you just bullish? Or do you really think 25 is FAZ’s natural resting price? I ask because if FAZ zooms to 30, the fly becomes worthless. That’s another risk.
    You may prefer to buy a bull spread. The premium is higher, but if FAZ moves as anticipated, you win at any price above 25. It costs more to buy this spread than a fly, so it depends on your specific reason for wanting to own a position in FAZ.
    I don’t know which strikes to choose, but you can consider the Apr 20/25 call spread. If you find the premium is too high and you’d like to pay less, you can also sell an OTM put spread: Apr 15/17.5, or other strikes. In fact, you can sell the put spread and not buy the call spread. If bullish, that’s a decent play and you win if FAZ rises – it doesn’t have to go near 25.

  8. CHAKRA 03/27/2009 at 1:24 PM #

    Hi Mark
    I will appreciate if you can tell me the PROS and CONS
    of WRITING COVERED CALL in this situation.
    I own 1000 shares SUNCOR. To day is trading for $23.68.
    I can write LEAPS CALL-25 for JAN 2011 for $7.70 OR
    I can write APR 25 CALLS for $1.15.
    Since don’t mind my stocks CALLED AWAY (GET ASSIGNED)
    Is it better to WRITE LEAPS CALLS?
    I can earn $7700 right away. So why WRITE APRIL CALL 25?

  9. Mark Wolfinger 03/27/2009 at 1:39 PM #

    I like this question because it give me a chance to clear up some common misconceptions.
    1) You DO NOT ‘earn $7,700 right away.’
    You collect $7,700 in cash right away. That gives you some good protection if the stock price declines. And it gives you cash that can be invested elsewhere. But you have not earned anything.
    2) If you ‘don’t mind’ being assigned an exercise notice, it does not matter which call you sell.
    3) If you prefer to be assigned, then it’s better to write options with less time. When you write LEAPS calls, there is no chance you will be assigned anytime soon.
    4) There are two major reasons for writing covered calls
    a) generate income
    b) gain downside protection
    Each investor has his/her own comfort zone and investment objectives. If you want good protection coupled with the chance to earn a good profit, then longer-term options are for you. Although it doesn’t have to be as far out as 2011 LEAPS.
    If you want a chance to earn more money (higher return on investment), then you want to sell shorter-term options. These decay much faster and if (yes, it’s a big if) the stock doesn’t tumble, you can collect a decent premium every month or two. Over time, this provides the opportunity to earn far more than $7,700. But, there’s very little protection against loss.
    Thus – which is more important to you? Protection plus a good profit opportunity, or more potential profit with greater risk of loss? That’s how you decide. And you are not limited to Apr or 2001 LEAPS. Any option between those is a compromise.
    That’s how I look at covered call writing (and options trading in general) – a compromise between taking more risk and trying to earn the maximum, or accepting less profit in return for a higher probability of success.

  10. Gil 03/29/2009 at 8:09 PM #

    ITM Covered Call
    Recently opening IC became kind of scary. Backspread might also be too risky. I would like to bring up to the table another idea: ITM Covered Call.
    For example, let’s take DIA, which closed at 77.81, with a modest body size candlestick, which implies uncertainty.
    The support lines are at: 72 and 69
    My suggestion is to buy a DIA lot and sell APR C 68; that is a Covered Write, just below the second support line.
    The price of the APR C 68 is at about 10.50 .
    If I manage to pay for this covered call just 67, I’ll purchase the DIA lot at 67, which is a nice discount from 77.81.
    What ifs
    1) If assigned I’ll selling the stock at 68, keeping a premium of $1 per share.
    2) If not assigned as long as the stock is above 68 I’m still in a good shape: I can sell the stock at more than 68, and also got the $1 premium.
    3) My only concern is if the stock plunged below 68 without being assigned, and I start to loose money. My suggested protection measure for this case is to purchase P 68 when DIA is at 68 before the APR expiration. My estimate for the cost is $2.50 at most, which leaves my maximum risk if I use this PUT at 250 -100(since bought stock at 67) = $150.
    Your feedback is highly appreciated
    Thanks in advance,

  11. Mark Wolfinger 03/29/2009 at 10:05 PM #

    1) There are always strategies that are too risky for some, but not too risky for others. An investor or trader must wait for trade opportunities that are suitable. It’s not a good idea to force trades. If uncomfortable, sit on the sidelines.
    2) Regarding the covered write, it’s simpler to sell the Apr 68 put. That trade is equivalent to the one you suggest.
    3) If assigned you sell DIA shares at 68. Agree. But your profit is not $1 per share. You collected 10.50 for the call, and that makes your selling price 78.50. Cost is 77.81 and profit = $0.69 (less commissions and carry costs). Note: the put is trading near 30 cents. Thus, your potential profit for this trade is far less than you stated.
    4) “If not assigned as long as the stock is above 68 I’m still in a good shape.” Sure, but that is essentially an impossibility, unless DIA closes expiration Friday @ $68.01.
    5) Buying the 68 put – if necessary to eliminate risk – leaves you with no position. If you do the covered write, then you would own a conversion, a riskless (except for pin risk. See Rookie’s Guide, page 133) position – or, if you begin by selling the 68 put, than would close the trade.
    You cannot make a good estimate for the price for an ATM put option without mentioning how much time remains before the option expires when you buy it. Thus, I don’t know if 2.50 is reasonable. The loss is more than $150. It’s nearer to $2.20 (2.50 – .30).
    Here’s my additional feedback:
    I don’t consider writing a DITM covered call to be a ‘new idea.’ To me it’s all part of the same premium-selling strategy. In this case, it’s a naked put (which is riskier than a put spread). In other words, you would be trading half an iron condor, but without protection.
    For me, 30 cents is too little to collect for the naked Apr 68 put. But because it’s below support and that strike price suits your safety needs, it may be a very good put for you (and that’s the bottom line) to sell. If the market opens lower Monday (3/30/09) you can offer your puts at the ask price and see if anyone buys them.