This volatility is simply amazing. Not too long ago, I mentioned in this blog that, for the VIX, 40 seems to be the new 30. Previously the VIX rarely stayed above 30 for more than a few days – but lately the 60 level has been the VIX’s new norm, and 70 has become a regular occurrence. Even more recently implied volatility (IV) of the market spiked even higher, and the VIX traded through the 90 mark. The upshot for options traders is that contracts have gotten super-expensive, as explained by David Graffen in WSJ Marketbeat recently. If you’re more bearish or bullish on an underlying than you would be with the upside-down split-strike (UDSS) described earlier, you might want to consider a close relative of the UDSS called a back spread. This volatility spread is a bit more risky overall, but correspondingly offers bigger upside gain potential if your forecast is correct.
(Now might be the right time to remind you: none of the following examples are meant to be recommendations, and these trades may not be suitable for all investors. Check with your investment professional and consider your own personal risk profile as you evaluate any investing strategy.)
Back spreads: the setup
Let’s start by picking a cheaper underlying than Goldman Sachs (GS), which I used in my previous example -- how about the Select Financial Sector SPDR (XLF)? This is an Exchange Traded Fund (ETF) representing the financial services sector and can be a useful security generally if you’re looking to play the action in this much-discussed sector. (I blogged on XLF earlier, so take a read for some useful background.)
It’s easier to do a bullish trade in backspreads, mostly because of how volatility skew works, so let’s take that route here. Volatility skew is a hard concept to summarize, but it’s worth briefing yourself on – take a read through my previous post to learn more about why and what it is. In brief, it refers to the fact OTM puts tend to trade for higher IVs than the OTM calls and are therefore more expensive in IV terms. Higher IV means higher cost and since we’ll be buying two OTM options for every near-the-money (or ATM) option we sell, it’s important to keep these facts in mind.
On 10/30/08 XLF was trading at 14.63. December option contracts have 50 days left to expiration.
Sell 1 XLF Dec 14 call at 2.10
Buy 2 XLF Dec 15 calls at 1.55
Net debit to the account = 1.00 [(2x1.55)-2.10 =1]
Your P&L graph at expiration looks like this:
Much like the upside-down skip-strike, the back spread is one of those “buy now, pay later” trades. If the ETF went to the middle strike right at expiration, the total loss for the trade would be $2.00 – that’s what we might end up “paying” for the entire trade. Since the max loss is more than the debit paid, you should expect to hold additional margin on reserve. For this example, the additional margin required is the width of the first spread or $1 (15-14). That’s 1 point or $100 for each 1x2 back spread executed.
Max Risk = 1 + 1 = 2
Max Gain = unlimited (but you need a big move)
Break-Even at Expiration = 15 + 2 = 17
Additional margin = $100 per 1x2 back spread
Looking for a big move, before expiration
This trade actually looks quite ugly at expiration. If the ETF moves in the direction you want but not enough, that’s when you’ll encounter your max risk scenario. That’s why this trade comes to mind during especially volatile markets, because we need a big move to make the trade reach the maximum profit potential.
What if you’re wrong about the direction – in this example, if the ETF goes down? That scenario puts your 1 dollar net debit at risk, but that’s still less risk than if we just bought the 15 call outright. As of 10/30/08, that cost was $1.55 per contract. That is over 30% in additional risk if you just bought the call.
The upside is unlimited, but the trade is definitely looking for at least a one standard deviation move. (You can learn more about what a “standard deviation” is and how it’s used in calculating implied volatility here.) Its total downside risk at expiration ($2) is more than the cost of buying the 15 call outright. Because of this we should not plan to stay in the trade until expiration unless the trade has made the extreme upside move mentioned.
If you look at the below P&L graph, you’ll see that, as expiration approaches, the downside risk increases. Please see the red line in the graph, indicating P&L for the trade on day one. The red line assumes all things being equal to the conditions on day one (no change in volatility, time to expiration, carry costs, etc.). With each passing day the red line will start looking more and more like the green line at expiration.
What that’s telling you is timing is very important to this type of strategy. If the most risk occurs in that last week to expiration, we’ll definitely look to get out of the trade if the ETF is close to the 15 strike with expiration fast approaching. Please make sure to study the strategy in the TradeKing Profit + Loss Calculator before putting it on.
Just to put some perspective around these examples: this trade makes the most sense when implied volatility is extremely high. In the case of the XLF, the same option contact a year ago had an ATM implied volatility of 30% and was trading for 33.58. As of this writing the XLF was at 14.63 and has an ATM implied of around 80%. See the difference?
If you buy the XLF 15 call outright and the market does go up, IV will tend to have an inverse relationship to the market and probably decrease – not a pretty picture for a long call holder. With the back spread under the right conditions, we have both long and short legs, which may help offset this occurrence if your forecast is correct. It will not be a perfect hedge against the dreaded volatility crunch, but should help somewhat if it does occur.
I’ll try to keep the ideas coming for more trade ideas specific to volatile conditions – but hit me with your questions, too. These are undoubtedly strange times, and I’m sure you’re encountering scenarios that prompt questions. Remember: I’m happy to help you get ‘em answered!
Regards,
Brian (Og)
[image: Untitled by on Vidiot flickr]
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options.
While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.
Any strategies discussed or securities mentioned, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities.
Please be aware that early assignment of short options on American style expiration options may affect the overall max profit and loss potential of the strategy. Please plan accordingly for this possible occurrence.
