Back Spread

By definition, a back spread is a position that contains more long options than short options. The two predominant Greeks are positive gamma and negative theta.

The primary reason for owning a back spread is to earn a good profit when the stock makes a big move in the direction of the extra options (i.e., down for put bask spreads and up for call back spreads).

The extra option owned are almost always out of the money when the trade is made. They could be ATM, 50-delta options, but that is less common. The options sold are often ITM, but they can also be OTM options.

If possible, it’s is preferable to open these trades with a cash credit. Why? If the trade is a call back spread, and if the market moves much higher, per our initial expectations, then we have the chance to earn a good profit. However, if the market falls, it would be nice to earn a smaller profit – or at least not incur a loss. If all options expire worthless, and if we collected cash when making the trade, then we earn that cash credit as out profit when the market falls. However, it is not that easy.

Today, let’s make the trade and look at risk graphs. As the days pass, I’ll add commentary and talk about the pitfalls of trading back spreads.

The Trade

There are many possible choices and this trade is being made for educational purposes. Please do not open this trade for your own accounts. I would not consider it for mine.

This specific trade is very short-term. The options cease trading Oct 20 and settlement is Oct 21, based on the opening prices of each component of the index.

Quotes

For the trade, I’ll assume a cash credit of $3.15 for each 2 x 1.

One of the problems with this trade is that the size is not very large. That means we don’t accumulate enough delta to make adjustments very often. Note that gamma is only 1 right now. I recognize that the small trader may want to take a careful look at back spreads as a potential strategy. However, I hope that this study provides an opportunity to discover that this type of trade is costly to maintain. Theta is negative, and is pretty large, considering position size.

Risk Graph

October

I chose October options for two reasons: High gamma (high compared with other expiration dates), and relatively low dollar cost for the options. With those benefits comes the high negative theta that requires that a rally occur soon or that the market declines and we get to keep lost of the cash credit. This is another trade that we do not want to own on expiration day.

The BIG Risk

One of my problems with back spreads for the retail trader is that such traders tend to hold onto their trades too long. I’m sure that is less true for Options for Rookies Members because we constantly mention the risk associated with holding positions too long.

Take a look at the risk graph. Focus on the blue dotted line. That’s the risk graph that describes the position when expiration arrives. Sure it’s an unlikely event, but if the underlying settles anywhere near 710, losses can be significant. That’s the true risk for back spreaders. As the market rises – slowly – the short option can increase in value as it moves into the money. At the same time, the options owned move towards worthless. It’s a steady, day-after-day loss, and it becomes increasingly more difficult for the trader to pull the trigger to exit the trade.

These back spreads look easy. The risk graph shows much profit potential. However, theta risk and the risk of little or no movement of the underlying stock or index is real. Of course, there is also the idea that RUT 780 calls are far enough out of the money that the bearish trader can like this position. There’s always a decent chance that all, or most of, the $315 x 5 credit collected will remain in the hands of the trader as the profit for the trade. That’s what makes the trade so tempting.

October 6 Update I. The opening

Oct 6. Quotes

Oct 6 Risk Graph

Oct 6. Risk Graph. Closeup

RUT is 12 points higher
IV (looking at the 680C is one point lower
The trade midpoint is now $3.90. We could have opened the trade today and collected $0.65 more cash

So far, not so good. RUT is 2% higher, but IV is one point lower and one day has passed. Yesterday’s vega and theta were $82 each, suggesting a loss of $164. The observed loss is larger ($65 x 5, or $325). When dealing with wide bid/ask spreads, the midpoint only approximates the true markets. Thus, unless we enter an order, we do not know the true size of the current loss.

October 6 Update II. The close

Near the end of the trading day, Rut was up another 14 points. That marks an advance of >4% in two days. That should be good news for the back spreader.

Oct 6, 2011. RUT now 672

The bid/ask midpoint is now $3.60. We are still losing money.

Risk Graph. Oct 6. End of day

At this point, we are long 28 delta, and that’s enough to sell one Oct 810 calls. I’m noting doing that because the upside has been difficult enough, without reducing delta. Let’s remember than one objective of the back spread is to achieve a big win when underlying asset moves far enough. That conflicts with the gamma scalping objective. Right now, no call sale.

Our time decay has increased to $207 per day, and that’s big. In exchange, we now own 3 positive gamma. It’s going to take a big up day for that gamma to pay off. With the weekend coming, it’s going to be necessary to do some adjustment – if the market moves much higher.

Friday, October 7 Morning

The numbers are bad this morning. One of the reasons is that the market makers sometimes accelerate the clock, to account for the weekend’s time decay. Whether this is a good or bad idea is not the point. It often means that the bid/ask quotes take that into consideration, and long theta positions can suffer.

Oct 7. One half hour after the opening

Oct 7. One half hour after the opening

The quotes tell us that we can now enter the order and collect a credit of $4.10 (midpoint). We lost some delta (now only +8), so there is no adjustment to be made without a rally.

I want to mention one important point about gamma. Gamma measures the rate at which delta changes per ONE POINT change in the underlying stock. This is a $670 ‘stock.’ If we were trading IWM, gamma would be much larger because the underlying is only $67. In other words, RUT gamma is concerned with a move from 670 to 671 while IWM gamma looks at delta change from 67 to 68 – and that is equivalent to a RUT move from 670 to 680. Thus, RUT gamma looks small, when it is really larger than it appears.

To avoid possible confusion, let me clarify a bit:

• RUT gamma is the number we seen in the risk graph
• RUT gamma is small
• When RUT moves from 670 to 680, that is equivalent to IWM moving from 67 to 68
• IWM gamma is much larger than RUT gamma because the option values change mush more quickly – PER POINT IN THE UNDERLYING
• Thus, if you want to see a higher gamma, just create the position using 10 x as many IWM options (see below)
• Reminder, IWM options are ‘live’ all day Friday, Oct 20, and RUT options settle at the opening

IWM options show an equivalent trade

Note that gamma is much larger and that theta is in the same range.

Update October 10, 2011. End of day

RUT up more than 28 points and the position is long 33 delta. Unfortunately time has taken it’s toll. We are now short one ITM call and long 2 OTM calls. We need another big upside move or at least a rally without an IV crush.

RUT now 485. End of day, Oct 10, 2011

Oct 11. 8:36 AM CT

The midpoint is now $6.40, as this trade bleeds money.
The positive delta have disappeared and theta is not as bad. To make money on this trade, our best chance is to see the market decline so that we can buy those Oct 680 calls at a very low price. Right now, that does not appear to be a likely result.

RUT 678.12. October 11, 2011. 8:36 AM CT

Oct 11. End of Day

Time is the backspread killer.
Midpoint now $7.10
To me, a trader would have no good way to make a hold/exit decision. That’s one reason why I find these to be so troublesome for the retail trader.

Oct 11. Three minutes prior to the close of trading

October 12. 8:42 AM CT

Midpoint is now $7.45.

Oct 12. 8:42 am CT

Long 45 delta as the market rises. But the rally is not yet sufficiently large with theta being over $400 per day to own this small position.

Oct 12. 8:45 am. RUT now 695

Oct 12. 2PM. RUT + 14 today

We are picking up some delta, but my guess is that we will not be picking up much in the way of dollars until the 710 calls are ITM – assuming they ever get there. Time decay is also getting worse, as expected.

Midpoint now $6.90

+6 gamma is big, especially for a $700 underlying. Unfortunately, vega is >200 and this today’s rally is accompanied by the expected IV decrease. That’s a big part of why we are losing money [But theta is bigger].

Oct 12. 2PM. RUT = 703

Oct 13. 8:32 am

Oct 13. 8:32 am

midpoint $7.20

3 hours later. Oct 13, 11:44 am

This just keeps getting worse.
Midpoint $8.75

Look at that midpoint!

Oct 13 1143 am

Market rallies again.
Midpoint now $10.05
Dare we sell something as a delta adjustment? At this point, I’m electing to hold. Remember that this is a theoretical trade, and it’s performing as I hope it would. It’s important to demonstrate how these beautiful-looking risk graphs can come with spreads that fare very poorly.

Oct 14. 8:35 am

Risk Graph. Oct 14, 8:35 am

Oct 14. 2PM. Serious deltas

We now have some serious deltas, as the long calls are now ATM. Unfortunately, we are heading into the weekend and theta is high.
This is high risk/high reward.
Midpoint has declined to $8.65

At the money!!

$700 per day in time decay.

Oct 17. 8:33 am

The downturn is not what we needed at this stage. We suffered as the market rose to the previous close, and it was time to make some money on a continued rally (if it did not move too slowly).

Trade midpoint: $11.40

Oct 17. 8:33 am

Oct 17. 8:34 am

Oct 18. 8:37 am

Midpoint: $11.85

This position should not be held by anyone except for the big gambler.
The problem is deciding when to exit. My inadequate solution to that dilemma is to avoid the trade in the first place.

Oct 18. Quotes; 8:37 am

The sad-looking risk graph. Oct 18; 8:37 am

Final Entry. Disaster

My inability to watch this trade as expiration approached, coupled with the ‘worst possible’ result (okay, it could be a bit worse), results in the maximum loss.

With RUT settlement (ticker symbol = RLS) being 709.83, out longs expired worthless and the short option was $29.83 ITM. Thus, it cost $2,983 to exit the trade.

The good news is that this situation does illustrate that pretty risk graphs do not guarantee pretty profits. Back spreads are not easy for the retail trader.