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9 Weeks to Better Options Trading: Back Spreads


Veteran options trader Steve Smith breaks down the back spread.

Immediately after the numbers hit, implied volatility in the May options dropped from 39% to 22%. As I wrote in an OptionSmith Alert that morning, "looking at the report, I think the stock should be down $50." You would have had to be awfully quick though, and I wasn't nearly so on getting out of the long side of a broken butterfly, but with the stock near $650 on the open, one could have:
  • Sold 1 May $630 put at $12 a contract
  • Bought 4 May $600 puts at $3.50 a contract
This is a $2 net debit (4 x $3.50 = $14, and $14 - $12 = $2). The notion is that if shares of Google kept going higher, the loss is limited to $2.

On Monday morning, with shares of Google dipping below $605, the $630 put was around $33, and the $600 put was around $15, making the position worth around $27, for a 1,250% increase. (Note: 4 x $15 = $60, and $60 - $33 = $27)

This is a bit of a rigged example, as these gains occurred on a huge move in the stock, and as implied volatility in the May options bounced back above 25% following the initial post-earnings decline. But the point is, it illustrates how the gain in implied volatility worked in conjunction with the directional move in the stock to generate a big gain.

This happened for two reasons.

First, an increase in implied volatility will pump up out-of-the money options more than in-the-money ones. So since we're long the out-of-the-moneys, an increase in implied volatility is clearly beneficial. Second, all things being equal, an increase in implied volatility increases the value of an option. Since we're long more contracts than short, we profit here as well.
No positions in stocks mentioned.

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