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9 Weeks to Better Options Trading: Back Spreads

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Veteran options trader Steve Smith breaks down the back spread.

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Now let's look at what would have happened had you established a similar position in Apple (NASDAQ:AAPL) last week when it crossed the $600 billion market cap around the $640 level. With earnings coming next week, the implied volatility has jumped from 33% last week, to 43% on Monday.

On April 9 one could have:
  • Sold 1 May $620 puts at $23 a contract
  • Bought 3 May $590 puts at $13 a contract
This would be a $16 net debit (3 x $13 = $39, $39 - $23 = $16).

On Monday, with shares around $590, the position would have been worth around $99 for a 618% increase. The lower return relative to the Google trade is due to Apple starting with a higher implied volatility, making it harder to establish a higher ratio of long to short; we had 4:1 in Google and only 3:1 in Apple for a higher cost. This highlights how important it is to use a back spread when implied volatility is low and set to rise.

So ultimately, the the best time to use a back spread is when a stock or ETF has enjoyed a remarkable rally, and is set for a fall in price, while implied volatility is low. This is because the low IV will allow for an attractive long to short ratio since with low IV, we can buy more of the out-of-the-money options. And when that IV rises, the out-of-the-money options we are long rise in value.

Sounds perfect, right? Not so fast!
No positions in stocks mentioned.

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