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]
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.
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.
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.
Coming Monday: Special Promotion for new subscribers to Expiring Monthly:
Thank you gifts from us to you. We'll be giving away, books, a mentoring session, and a trial newsletter subscription. Still looking for more gifts.
Complete details available Monday March 15, 2010