Tag Archives | vega risk

Diagonal Backspreads

Hi Mark,

I have a question on ratio diagonal spreads that I was hoping you could answer for me.

The spread is as follows: Sell 1 ITM Option, Buy 2 OTM Options where the IV of the front month option is higher than the IV of the back month options (e.g. Sell 1 ITM Nov Call, Buy 2 OTM Dec Calls).

I noticed that the position will lose money if the IV of the Dec options (the ones I am buying) declines. What type of adjustments can be made to this position if the IV of the long options starts to decline?

Thanks

D

***

The backspread is one strategy that I seldom discuss, primarily because it's not easy for individual investors to manage.

The diagonal backspread is a separate category and is worthy of a discussion. 

By definition, the backspread is an option position in which the trader owns more options than have been sold.  Thus, your 2:1 spread qualifies as a backspread.


Vega Risk

When owning options that expire later than the options sold, one unchangeable characteristic of the position is long vega.  Thus, the P/L picture is significantly affected by changes in the implied volatility (IV) of the options – between the time the position is opened and closing time [And that's true whether you exit voluntarily or hold through expiration].

The simplest method to guard against an IV decline is to sell vega.  And the simplest method for doing that destroys the very reason you opened the trade in the first place.  That method is to change the diagonal backspread into a 'regular' backspread.  For example:

a) Sell two Dec/Nov OTM calendar spreads.

This leaves you with the Nov back spread:
Long two Nov OTM; short one Nov ITM
It is not likely that you want to own this position

b) Sell one ITM calendar spread

This leaves you with the Dec back spread
Short one Dec ITM and long two Dec OTM

This idea is unsuitable.  Traders who use diagonal back spreads have a very different market outlook (expiration to arrive with the near term option's strike price being near the underlying price) than those who own  same-month backspreads (hoping for a very big move – so big that the ITM option is very far away from the price of the underlying).

It's nice when the simple method is viable, but in this case it is not.

A more complex solution is to add new positions with negative vega to your portfolio.  However, this requires trading several positions simultaneously, and not every trader wants to do that.

 

Suggestion

In my opinion, no single strategy is good enough to use all the time.  We must pick and choose our spots.  When IV, as measured by VIX, or better yet, the IV of your specific underlying, is relatively high – and you have no reason to anticipate that it will move higher – that is not a good time for owning positions that are vega rich.

I get it.  You still want to make the play that pays off when expiration finds the stock trading near the strike of your ITM short.  If you have a very strong predictive ability, and if you want to make that play, there are alternative strategies that have less vega risk.  (Butterfly for example).

However, if you predict market direction and future prices, then you should be willing to predict the IV direction as well.  There's no need to get it exactly right.  But, if you believe it's not going higher, I would avoid the diagonal backspread.  That spread is most appropriate when you have some reason to anticipate that IV will not be declining over the next few weeks.

I agree that this is something difficult to predict, but the diagonal backspread comes with vega risk.  You must deal with it or only accept that risk only when willing to do so.

If you insist on using this strategy because you had good results, consider trading smaller size when not confident about future IV direction, and larger size when confident it will incease. 

Another possibility is to divide your trade into two parts.  One is to use your diagonal, but in addition, perhaps you can sell a credit spread with strike prices that suit your prognostication.  That credit spread comes with negative vega.  It won't have as much vega as your diagonal backspread, but it is a hedge in that it partially offsets vega risk.

The bottom line is that it is easy to hedge delta risk, but vega is another matter.  The hedge is to sell vega, and that is difficult when owning diagonal backspreads.

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Writing Calls Against LEAPS. Vega Risk

TradeKing webinar today, 5PM ET.

Adjusting Iron Condors Part I



Hi Mark,

OK I did my homework on the following scenario and I am
confused.

My original idea was to buy
LEAPS VLO Jan 15 @ 4.35 and short Sept 18 Call at .40. You said:
"The volatility is more than a consideration. This trade is very vega
sensitive and I believe that if you make this play repeatedly, your
results will be based on IV."

I compared the HV [MDW: Historical volatility] and IV and they are relatively close at this point. [MDW:That tells you that IV may be at a reasonable level, but does not describe potential risk.]

I ran the numbers with IV decreasing and it does affect LEAPS pricing.  However, doesn't that imply the stock price is more
stable because IV typically decreases on rallies?  [MDW: Not always.  IV does rise and fall for reasons other than how the market has been recently trading.  And IV for a single stock can easily get separated from 'market IV']

I went to the CBOE site and ran the numbers, but my more important question is
this: I purchased the 15 strike LEAPS.  Let's
go worse case to the upside and assume company is a takeover target @30.00, with the deal closing before my short options (Sep 18C) expire.

This is how I am viewing the trade:
My long 15 call is worth 15+ any time value. [MDW: There will be zero time value if the takeover is for cash]
My short 18s  cost 12 and the loss is $11.60.
Although not profitable at this time [MDW: 'at this time'?  There is no other time.  You will shortly have cash and no investment], my net cost for the investment is 3.95 (4.35 – 0.40)…

My cost at
this point is 3.40 (15-11.60) exposing me to a .55c loss  [MDW: This is not an accurate calculation.  Your cost remains $3.95, per the previous paragraph,  The position is now worth $3.00. That's a 0.95 loss]

[MDW:Please let me know what part of the trade I am missing.

Don, You are missing the fact that a 95-cent loss on a $3.95 investment is a very bad result.  A 24% loss is significant.

You used a single, low-priced stock, trading with a 33 IV and want to discover generic rules that apply to all situations.  You see the dollars lost as a number, and not as a percentage of the investment.  That's not reasonable.  Try this with AAPL and consider the results.

As we know there
is no reward without risk but I see the two risks: 1.
Stock sinks;  2. Dramatic upside
move.
I am interested in hearing your thoughts. 

Yes, those are two of the risks.  Add another: an IV decline not related to a rally.

b) "Do you understand that by the time the stock hits 19, you are short
delta and continue to lose money on a continued rally?"

I don't get this
part and I am really trying to understand.  [The delta of your short option becomes higher than the delta of your long option.  Hence, you are net short delta and lose money on a price increase]


c) Look at the stock trading at 20. Drop IV by 25%. How does the trade
look now? How about 21 on the stock and IV down 50%?
I have not made any of these calculations. That's your assignment.  When
trading LEAPS, you want to know, not guess, what happens in a bunch of
'what if' scenarios.


OK, I did this hundreds of ways so that other readers and you can pick
apart my thinking:
I used 40% IV and then reduced it to 20% for VLO. 
I set up the trades as mentioned above.  [MDW: Don, The assignment was to help you decide if you really like this type of trade. My looking at the numbers does not help you develop a plan.

Is the risk/reward reasonable?  Can you make a wild stab at the potential reward?  What if IV declines and you must sell options @ 20 cents instead of 40 cents?]

[Don goes on to offer data, if you care to see the details, click here]


Thanks for reviewing this.  Hope I set it up in a way that makes sense.

Don

Yes, it makes sense.  But the data is for you to review

The bottom line remains.  When you own LEAPS, a plan such as yours is not unique.  Many try this plan, and everyone who adopts it owns the LEAPS for a long time.  The price of that option is very susceptible to changes in IV because these options are rich in vega. 

The other factor that followers of this strategy ignore, is the possibility that the monthly income stream can be cut in half or worse, when IV drops or the stock price declines.

This strategy can prosper.  But it has more risk than you see. 

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