How Kite Spreads can Become Embedded Back Spreads

James and I have had a back and forth discussion regarding whether certain positions are back spreads.  The discussion began here and there's an interesting aspect that's worth consideration:

How can a kite spread – in which you own a limited number of long options (on top) turn into a position with back spread properties?

First, some definitions:

a) A kite spread is generally purchased as insurance when an iron condor or credit spread threatens to move into the money.  It's either a bullish position using calls, or a bearish position using puts.  It's constructed by buying one option (the kite string) and selling (usually) 3 or 4 farther OTM vertical spreads (the kite sail).  A more detailed description is available.

b) 'On top' means closer to the money.  It's a call option with a lower strike  than the options being protected.  Or it's a put option with a higher strike than the options it is protecting.

Example:  Please note:  These are randomly selected fictional trades, generated today, with RUT @ 675.  I don't have prices for these 'old' trades. The discussion involves the appearance of the portfolio, how it came to be constructed and says nothing about profitability.

Assume you sold 20 call spreads:  RUT Apr 650/660 when RUT was trading below 600. 

As RUT moved above 620, you became concerned about the position and decided to make an early adjustment (a Stage I adjustment). The trade you chose was to buy 2 RUT Apr 640; 670/680 kites [This is the C4 variety]

Adjustment I:

Buy 2 Apr 640 calls

Sell 8 Apr 670 calls

Buy 8 Apr 680 calls

You now own 2 Apr 640 calls and are short a total of 28 call spreads

The market continues to move higher, and when RUT passes 635, you are very uncomfortable with your position.  It's time (you decide) to get out of some of those 650 calls.  The simplest trade is to buy back a few of the Apr 650/660 [typo corrected] call spreads, but you decide to buy kite spreads instead.

You buy 5 Apr 650; 670/680 C3 kites.

Adjustment II:

Buy 5 Apr 650 calls (to close)

Sell 15 Apr 670 calls

Buy 15 Apr 680 calls

Comment:  Increasing position size is usually a poor choice.  The reason it's acceptable with a kite spread is that the adjustment trade (as a stand-alone position) adds no additional risk to the upside, other than the debit incurred when placing the trade.  It does provide plenty of upside profit potential when RUT is not near 680 at expiration.

When RUT moves past 640, one reasonable trade is to sell the 640/650 C spread.  This feels counterintuitive, especially when the upside is where risk lies and making the upside worse doesn't feel right.  But if you sell this spread between $6 and $6.50, the maximum loss is only $350 to $400 per spread and it does make the down side better.

The true rationale for selling the call spread is to use the proceeds to buy more kites, reducing my short position on the 650 line.

Adjustment III

Sell Apr 640/650 spread 2 times

Buy 3 more Apr 650; 670/680 kite spreads

The position now looks like this: [with errors corrected]

– 10 Apr 650 calls

+20 Apr 660 calls

-32 Apr 670 calls

+32 Apr 680 calls

James calls this a back spread and I'd prefer to describe this position as one that contains a back spread within.  The characteristic that gives this backspread-like properties is the fact that the extra long options are no longer 'on top.'  The long option is the April 660 call.

To completely eliminate backspread characteristics, there are alternatives:

a) Buy 5 Apr 650; 670/680 C3 kite spreads.  My preferred choice

c) Buy 5 Apr 650/660 C spreads. Perhaps sell one extra Apr 660 call to offset the cost cost, but only if the risk graph and your comfort zone allow that trade.  I see no good reason to make this trade

c) There is no necessity to make these trades, but if looking at the 'backspread' portion of the position is uncomfortable (too much negative theta), you can take steps to alter the position

That's how kite spreads can turn into positions that resemble back spreads.  And the process continues.  With RUT currently trading near 675, it's likely that anyone holding this position would have repurchased many of the 670 calls as part of a kite that sold more 690/700 spreads.


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14 Responses to How Kite Spreads can Become Embedded Back Spreads

  1. james 03/12/2010 at 8:34 AM #

    There are some great discussion points in your post, but before we get the debate going can I check we are on the same page; I have the trades you illustrate as
    -20c 650 / +20c 660
    +2c 640 / -8c 670 / +8c 680
    +5c 650 / -15c 670 / +15c 680
    -2c 640 / +2c 650
    +3c 650 / -9c 670 / +9c 680
    If this is the case then the position after Adjustment 3 is -10c 650 / +20c 660 / -32c 670 / +32c 680 and not as you indicate of -5c 650 / +15c 660 / -32c 670 / +32c 680.
    Would you please clarify.

  2. amin@regencycrystal.con 03/12/2010 at 8:36 AM #

    The market continues to move higher, and when RUT passes 635, you are very uncomfortable with your position. It’s time (you decide) to get out of some of those 650 calls. The simplest trade is to buy back a few of the Apr 550/560 call spreads, but you decide to buy kite spreads instead.
    I guess 550/560 is a typo

  3. Mark Wolfinger 03/12/2010 at 8:37 AM #

    Yes indeed, Amin
    thank you

  4. Mark Wolfinger 03/12/2010 at 8:50 AM #

    Thank you James
    This seems to be the morning for eagle-eyed readers.
    I appreciate the corrections

  5. james 03/12/2010 at 9:14 AM #

    Mark, no problem, would the amended position then also slightly change the alternatives at the end of the post to eliminate the backspread characteristics, cheers, James

  6. Mark Wolfinger 03/12/2010 at 10:02 AM #

    Just the size of the trades.

  7. james 03/13/2010 at 8:08 AM #

    Hi, I don’t quite see how your alternative adjustments [buying more Kite spreads or buying call spreads] to eliminate the backspread characteristics would work in practice.
    Do you have any risk graphs that would illustrate these?

  8. Mark Wolfinger 03/13/2010 at 10:44 AM #

    I’d like to provide a response you can use. I just have no idea what you are looking for. I don’t quite see what it is you want.
    When you say ‘work in practice’ – are you telling me that:
    a) The trades cannot be made
    b) The trades will not eliminate the backspread characteristics of the position?
    c) The trades won’t make money?
    What is your point? What is it you want to know? Of you don’t want to know anything, then what is it you are trying to tell me?
    I don’t see the purpose of your comments. Please explain in simple, understandable language. I just don’t get any of this.

  9. james 03/13/2010 at 1:32 PM #

    If you are happy to kick this around a little more;
    1. The adjusted position ended up as -10 650/+20 660/-32 670/+32 680
    2. Your preferred choice to ‘eliminate the backspread characteristics’ was to buy 5 Kite spreads; +5 650/-15 670/+15 680 [or possibly more Kites given corrected position]
    3. This would leave a position of -5 650/+20 660/-47 670/+47 680; which seems to retain, not eliminate, it’s embedded backspread characteristic.
    I am simply trying to reconcile your objectives and the adjustments you suggest, which don’t quite make sense to me when I replicate in a risk graph.
    Is there a way I can send you the risk graphs directly and we discuss this off line to iron out the wrinkles.

  10. Mark Wolfinger 03/13/2010 at 3:04 PM #

    You are asking no questions. You are making no contribution. In short, I have no idea what you are doing.
    I gave you a chance to tell me what you are doing, but you did not respond.
    If you want to kick it around, sure send the graphs. Also send $300 for the first two hours of private consultation.
    Look at it this way: The position is short the top call spread.
    After that it is a kite. Long top calls and short bottom call spreads. No back spread.
    James, I like having discussions with readers. I want to encourage more of that. But I don’t know what to say to you.
    The common back spread owns OTM options, looking to profit from explosive gamma. These high delta 660s lose gamma as the stock rise. LOSE GAMMA. GAMMA MOVES TOWARDS ZERO. That defeats the purpose of a back spread.
    What is is you want to ask or relate? It does not matter if it makes sense to you.
    It was not a recommended trade. If it does not suit you, don’t do it. If you don’t see the purpose, don’t do it.
    I’m here to have a worthwhile discussion with anyone. This discussion is not worthwhile (in my opinion). It is pointless.

  11. james 03/15/2010 at 6:51 AM #

    I am a liitle surprised that you find the discussion pointless.
    I normally agree with 95% of your posts, I just happen to disagree with the conclusion you have reached in this case.
    Whichever way you wish to dissect this position, the embedded backpsread is evident.
    1. The raw position of -5 650/+20 660/-47 670/+47 680 contains a -5 650/ +20 660 backspread that is in front of and protecting the 47 short 670/680 spreads.
    2. If you dissect out the embedded butterflies; -5 650/+10 660/-5 670; +10 660/-20 670/+10 680; you are left with a -22 670/+37 680 backspread.
    3. If you plot the position on a risk graph, it is self evident that the ‘predominant’ feature of the position is the embedded backspreads.
    Specific questions;
    1. Do you agree that the raw position has an embedded backspread?
    2. If not, what do you see as ‘protecting’ the short 670/680 call spreads?
    3. Are you prepared to post a risk graph of the position that would illustrate this type of trade?
    Please do not be offended with my comments on the basis that I disagree with your conclusions, I do hope you are prepared to continue this discussion.

  12. Mark Wolfinger 03/15/2010 at 8:59 AM #

    You have not mentioned any conclusion, so how can you disagree with it?
    1) My arithmetic was off. Ok. I agree.
    2) It’s true that you can view any position in a myriad of ways. That’s the beauty of synthetics.
    3) One portfolio can be broken down into separate positions. It is not necessary to look at a position in its entirety.
    4) I choose to view this as short a few lots of the call spread and then long 660s vs. a bunch of verticals. That’s my choice. If you prefer to look at it differently, that’s your choice.
    What difference does that make? Note this is a question. Please rely.
    5) Let’s say I look at it your way and agree that it does have an embedded back spread. Here are my question for you: So what? Who cares? What difference does it make? How does that alter the way you manage the position going forward? And most importantly: what is it you are doing?
    Exactly what discussion do you want to continue? There is no discussion. There is just you insisting that there is an embedded backspread. Fine. You win. There is an embedded back spread.
    So what? Who cares? What’s the point?
    Since the days I began this blog – June 2008, I have never refused to respond to a question. I have been replying to email from readers for 10 years. I have never refused to respond to a question. There have been several thousand questions.
    Unless you tell me exactly what it is that you want to discuss, in specific terms – so that there is no misunderstanding possible, you will be the first.
    Cheers to you

  13. james 03/15/2010 at 9:52 AM #

    The point of the discussion was that you disagreed with my analysis that the position included and embedded backspread; which you now seem to accept.
    As you say, now seems pointless to keep flogging a dead horse.

  14. Mark Wolfinger 03/15/2010 at 1:11 PM #

    This particular horse was stillborn, and your quibbles provided zero benefit to anyone.