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:
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.