Backspreads. Standard and Diagonal. II

In Part I, I gave a brief description of a standard call back spread in which an investor buys more options than he/she sells.  The idea is to profit in a bull market when the underlying stock makes a big upside move – while minimizing (usually, eliminating) risk if the underlying moves in the opposite direction. 

Similarly, you may be able to profit in a bear market by owning put back spreads.

Back spreads allow the investor to own extra options and positive gamma.  Instead of paying for those options, the cost is reduced (or eliminated) by converting the position into a spread by selling fewer options that are closer to being in the money.  Typical back spreads allow the investor to profit when the underlying stock or index moves significantly in either direction. 

Because the focus of this series of posts is on diagonal back spreads, which are uni-directional, there is no need to dwell on that aspect. [But, if you want to understand how it works, consider yesterday's example.  Instead of selling May 90 calls, sell May 50 calls or stock.  Time decay becomes much worse, but gamma increases and if XYZ undergoes a serious decline, the back spread is very profitable – because the stock declines by far more than the May 90 calls would have declined.]

Diagonal back spread

The purpose of a diagonal back spread is to create an opportunity to earn a profit when the underlying makes a large move in one (specified) direction.  But, as with 'regular' diagonal or double diagonal spreads, there is the possibility of profiting when the option you sold is not far out of the money as expiration nears.  But keep in  mind that being short an ATM (at the money) near-term-option is a high-risk situation because of negative gamma.

Much of the profit/loss that results from owning a diagonal spread is dependent on IV (implied volatility) at the time you exit the position.  Diagonal back spreads are even more dependent on future IV  because you own extra options.  Thus, these spreads are especially rich in vega. [If that aspect of the trade bothers you, you can add some negative vega positions to your portfolio as an offset: sell credit spreads, for example.] 

I proposed the idea of diagonal call back spreads in Part I and suggested it's one method to profit from a major upside move  (use puts to play for the downside).  But there's one caveat:  Most of the time when the market rallies,  IV decreases.  That hurts a vega rich spread.  In very recent times, IV has not be declining on rallies, and for the moment, that specific risk may be minimal.

There are two ways to win with diagonal back spreads:

  • A large favorable move – The sooner, the better.
  • If time passes and your short options expire or are repurchased at a low price – as long as the market has not moved to a point where your long options have little value.

The Set Up

a) Choose an option to sell.  The idea is to sell a near-term (or 2nd month) option. 

You can choose an out of the money call – but not too far out.  This option must be trading at a significant price because you want to collect enough from selling these calls to pay (or almost pay) for the calls you buy.  The bakspread is not as effective when your cash outlay is large.  In that scenario, you'd be better off by simply investing the money in naked long calls – when looking for a big rally.

It's appropriate to sell an ATM option, if your comfort zone allows it.  Mine does not and I sell options that are a few strikes OTM.

b) Choose an option to buy.  This is a crucial decision.  If the market rallies and if IV declines, the best call options to own are those that with the lowest strike price (or highest delta).  But, if IV holds steady or increases, then the best options to own are those with higher strike prices.  Why?  Because you must own more of the lower delta options to achieve delta neutrality – and that translates into more vega.  If IV rises, it pays to own vega; if IV collapses, owning vega is costly. 

In addition, your potential upside win is larger when you own more options.  But be careful – time can destroy the position.  We'll look at risk graphs next time, but it's a good idea to use your broker's software to see how various positions make or lose money under various conditions.

Be careful here.  If you are considering the purchase of calls with a strike price of 700, it's reasonable to choose 710 or maybe 720 instead.  Don't consider buying 780s or 800s just so you can own a fistful of options.  That's a huge gamble that will cost dearly, unless IV explodes.

When trading an index, there are many choices.  That does not mean you can't adopt this strategy for individual stocks.  With stock, there are fewer choices – and that's okay (as long as you can build a position you want to own).

Each option has a different delta.  That allows you to build a ratio that appeals to you.  Because this idea is probably new to you, this is the perfect time to set up a paper trading account, open a variety of positions, and see how you feel about owning each of them – as time passes, and as the market moves.

EXAMPLE (Chosen almost randomly. Please do not make this trade.  The strike prices of the options you buy and those you sell should be as near to each other as possible.  But, the nearer they are, the more cash it costs to open the trade.  The only problem with a significant cash debit is that the spread can become a loser – if the market tumbles.) 

RUT is currently (Fri close) 429.

Sell 10 May 460 call @ 16.70; delta: -363

Buy 16 Jun 500 call @ 11.70; delta: +369

or   Buy 19 Jun 510 call @  9.50; delta: +352

or   Buy 25 Jun 520 call @  7.70; delta: +363

These are just three possibilities out of many.  You can sell Apr or May options and then buy May or Jun calls to hedge.

You can trade options with higher or lower strike prices – but it's important that the difference between the options you buy and those you sell are not 'too far' (a relative term) apart.

Next time: Choosing a spread

to be continued… 

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