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Back Spreads Insure Against Investing Catastrophes


A good play whether market soars or crashes.

Back Spread

This recent rally has left a lot of people scratching their heads. Personally, I've been scratching my back. As in, using a back-spread strategy as a means of establishing some low cost downside protection.

More for Less

A back spread consists of all calls or all puts with the same expiration in which one sells a closer-to-the-money strike and buys a multiple number of contracts in a further out-of-the-money strike. The result is to be net long the number of option contracts, which creates a position with a positive gamma.

In plain English, this means you're establishing a position that will benefit from a sharp or sustained directional move and an increase in implied volatility. With the major indices having run up some 50% from the March lows and now perched precariously at levels seen last October following the failure of Lehman Brothers, having some downside protection is a prudent course of action. In addition, with implied volatilities at 52-week lows, using back spreads to get long gamma might make sense.

A back spread has 2 distinct advantages: It allows you to buy more puts for less money, and if it turns out that the market keeps marching on, the net cost will be minimal (given the downside protection).

The goal of a back spread is to buy as many options as possible relative to the number sold for the lowest cost. A good rule of thumb would be to buy 3 contracts for every 1 sold for even money. Of course, width between strike prices is one the determining factors of what ratio can be accomplished.

Let's take a look at some numbers in the Spyder Trust (SPY) options. With the shares trading around the nice round number of $100, the August $101 puts can be sold for around $2.30 a contract and the August $97 puts can be bought for $0.65 a contract. That means a 4x1, buying 4 of the 97 strike puts and selling one of the $101 puts can be done for a $0.30 net debit.

Let's assume the market has even a modest 5% pullback in the next week bringing the S&P down to 950 the level, which has been deemed as support. The above position would be worth $2, or a $1.70 profit, or 550% profit from the initial cost. If the market continues to sink, the profits will mount at a near exponential rate.

The Dead Zone

The drawback is that there's a moderate decline that could lead to some steep out-of-pocket expense. Let's look at the worst-case scenario, which would be if the SPYs merely drifted lower and were at $95 on the August 21 expiration. The position would result in a loss of $3.70 for each 4x1 contract established. This is nearly double the cost of buying a delta equivalent of at-the-money puts.

One way to think of it is buying catastrophe insurance with a very high deductible. If the market stays healthy, you skate away with little cost and peace of mind. If there's a bad turn for the worse, you'll be covered. But if there are simply sniffles then you'll need plenty of tissues to sop up your tears.
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No positions in stocks mentioned.

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