9 Weeks to Better Options Trading: Back Spreads
Veteran options trader Steve Smith breaks down the back spread.
On April 9 one could have:
- Sold 1 May $620 puts at $23 a contract
- Bought 3 May $590 puts at $13 a contract
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!
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.
Copyright 2011 Minyanville Media, Inc. All Rights Reserved.
Daily Recap Newsletter