Backspreads. Standard and Diagonal. III

Part III: The risk graphs.

I apologize. All graphs were lost when the blog was migrated to WordPressPart I and Part II.

I discussed three different RUT diagonal back spreads last time.  Reminder:  These positions were selected randomly.  Thus, please do not try this at home.  If you are comfortable with this idea, carefully choose your own strike prices and underlying.  But these positions, or your own, are appropriate for a paper trading account.
 

RUT 429;(Closing price 3/27/2009) 

The y-axis shows Profit/Loss (multiply by 1,000).

P/L = 0 at current price (429).

The x-axis represents RUT price (multiply by 100).

Position A:

Sell 10  May 460C @ 16.70; Buy 16 Jun 500C @ 11.70



 

a) The position has positive theta.  That's true as long as there is significant time value remaining in the short option.  If RUT undergoes a significant move in either direction, the May options move towards 0 or 100 delta, and the time premium quickly disappears.  As that happens, theta for this spread becomes negative.

b) The position has positive vega. Thus, the final profit or loss can only be estimated.  So much depends on the price of your June options when it's time to sell.  Obviously, if you are satisfied with the profit (or unhappy about risk) at any time, simply exit the trade.

c) Note: This spread usually does not make a large profit, but it does provide the possibility of collecting when the market rallies.  If you are lucky and  RUT moves another 25% and if IV increases, there's money to be made.

d) There's another way to profit – and that's when the traditional diagonal spread would also be a big winner.  That occurs when the near-term option is inexpensive to cover, but RUT is still high enough for the Jun calls to retain substantial value.










Position B:

Sell 10  May
460C @ 16.70; Buy 19 Jun  510C @ 9.50




Buying 19 Jun 510 calls instead of 16 Jun 500 calls allows for the possibility of a larger gain.  But beware – if a move does not come quickly, the 19 Jun 510 calls will lose value more quickly than the Jun 500 calls.  

The position is + theta and vega (see Table below).  When vega is 408, the position makes or loses $408 when the implied volatility changes by one point; higher or lower.

Position C:

Sell10  May
460C @ 16.70;  Buy 25 Jun 520C @ 7.70


 

Potential profit is much higher, but theta is less (See Table).  Vega is much higher.  Thus, this position is far riskier then the others.  It's difficult to see from the current graph, but as time passes, the upside becomes ever more dangerous.  Right now this position works well on a continued rally, but if a few weeks pass, ans especially when IV declines, this can turn into a disaster.  [Sadly I lack the software to see these positions at a later date, but plan to post an update to these hypothetical positions.]

Table

3 Positions and the Greeks

 

DEBIT: Dollar cost to open position

286


8 Responses to Backspreads. Standard and Diagonal. III

  1. GMG 03/30/2009 at 9:30 AM #

    Nice series Mark, and I’m sure I speak for other rookies when I say that the graphs are very helpful!

  2. GMG 03/30/2009 at 9:34 AM #

    BTW, can you recommend any index option over the others for someone like me with a small account? Naturally, I’d like good liquidity and tight spreads, but it’s hard for me to buy more than a few RUT contracts without going over my max allocation per trade. I feel like I need to trade one of the minis (DJX, XSP, etc) to give myself enough flexibility to scale positions or buy additional insurance. Is one better than the others?

  3. Mark Wolfinger 03/30/2009 at 10:13 AM #

    The graphs take time, but I’ll use them more often.
    Instead of the minis, you can trade ETFs, such as QQQQ and SPY. They are NOT European exercise, but they have great liquidity and tight markets.
    I don’t know anything about the minis you mentioned, never having traded them.
    Can any reader provide insight?

  4. rluser 03/30/2009 at 5:24 PM #

    I do not know much about those minis, but MNX offers good liquidity and spreads on the $2.5 intervals. If you like the index, those options offer tremendous flexibility.

  5. Gil 03/30/2009 at 6:47 PM #

    These examples indeed demonstrate diagonal backspreads.
    What bothers me about these examples in partucular and backspreads in general is that you put your money on a bullish direction accompanied by specific price range.
    In spite of the 450 resistance, isn’t is just a gamble?!
    RUT might be above 460 at the May expiration but also below 500 (520, 530) at the June expiration. That’s why “I’ll not try it as home”, per your advice.
    Gil

  6. Mark Wolfinger 03/30/2009 at 7:24 PM #

    1) A back spread does not have a specific price range target. The idea is that a back spread is net long options – and with that comes the possibility for unlimited gains. Many times those large gains are possible in both directions. Diagonal back spreads are unidirectional.
    If you believe 450 is resistance, then there is no reason to own calls with strike prices above 500. On the other hand, it’s only your opinion that 450 represents resistance and others may feel differently.
    Then there’s this: If the May options expire worthless, and if you can sell the June options for more than the original debit, you have a profit. Thus, the final P/L is very dependent on the price of the options – and that means implied volatility. Thus, if you believe there is resistance at 450, then you can do a 1:1 diagonal spread. No need to own extras. Initiate the spread for a credit and there’s zero downside risk. Of course, there’s upside risk.
    Based on your beliefs, it would be very foolish for you to enter a trade similar to those examples. But, does that diminish the value of reading or writing about a different type of spread? Is learning something new a bad idea? You don’t have to adopt any method you believe is outside your comfort zone. It was merely an example of how a diagonal back spread works. I made it clear (more than once) this these examples were chosen at random and that it would not be a good idea to copy them.
    2) Isn’t any option investment a gamble? Isn’t any stock market investment a gamble?
    When trading options, I envision a scenario and try to find an option position that wins if that scenario comes true. Because I am not a good market prognosticator, I almost always adopt positions that are market neutral. That’s me. If you use technical analysis and have an opinion on direction, then choose a strategy that gives you appropriate positions to own.
    3)Your point 3 makes zero sense to me. First, it’s makes it obvious that you don’t understand how this spread works. You seem to believe that the price of RUT at June expiration is important. When May expiration arrives – or sooner – the position is closed. Thus, RUT price at the June expiration is 100% irrelevant to anyone who trades this position.
    If you don’t like a trade, don’t make it. The reason options are so versatile is that there is no need for ‘one size fits all.’ Adopt a strategy YOU like and others will do the same.
    By the way, I’m not a big fan of diagonal back spreads either. But, it’s one method for accumulating extra long options. It may not represent a profit center, but it works just fine as portfolio insurance.

  7. Gil 03/31/2009 at 2:06 AM #

    Mark,
    Thanks for your detailed response. I’ve learned a lot from it.
    I believe that all the posts and comments assist all of us in getting good exposure to portions of the options world. This one is not an exception.
    As for investment versus gambling. My approach is that unlike gambling where no strategies are in place, using hedged strategies which match the market conditions wisely are far from being a plain gamble. Actually I’m a kind of frustrated that in light of this crazy market, I’m not sure which strategy makes sense. And… when I’m not confidence what to do I just don’t play (using the time left to kearn from this form and to post these comments).
    Thanks again,
    Gil

  8. Mark Wolfinger 03/31/2009 at 8:44 AM #

    I only referred to ‘gambling’ because you asked if the spread under discussion was gambling.
    Agree, if uncomfortable with current market conditions or uncertain how to get involved, then it’s a good decision to sit on the sidelines.