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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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Editor's note: To help investors profitably navigate the options market, Minyanville is launching "9 Weeks to Better Options Trading," an educational series aimed at increasing trader understanding of the nuts and bolts of options, with an emphasis on real-world applications. In this series, veteran options trader and author of OptionSmith (Click here for a two-week FREE trial and get Steve's best trading ideas in real time) Steve Smith will demystify a range of topics from options pricing to trading strategies to special situations like earnings reports and takeovers.

For the first article in the series, click here.

If you are a novice options trader, we suggest you start with Steve Smith's 6-Week Options Trading Kickstarter series.

With market volatility picking up significantly over the past two weeks, the timing on our topics for this series has been pretty darn good.

Following last week's risk/reversal discussion, we are ready to explore another directionally aggressive strategy, but one that also benefits from an increase in implied volatility: back spreads.

A back spread is a position consisting of all calls, or all puts, with the same expiration, in which one sells a near in-the-money strike and buys a multiple number of contracts in an out-of-the-money strike. The goal is to have as minimal an outlay or debit as possible, while achieving a high ratio of long option contracts to short.

A good rule of thumb is to buy three contracts for every one sold for even money. I tend to use back spreads on the put side as portfolio protection, or straight-out bearish bets.

Let's look at the basic construction of a back spread using our old friend Google (NASDAQ:GOOG), which has been sliding following its April 12 first-quarter earnings report.

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.

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!

The drawback with a back spread comes when there is a moderate decline that could lead to a very steep loss, especially if shares drift between the short and long strike prices -- the area I call the dead zone. The short strike could be in-the-money while the long options remain out, potentially becoming worthless, making back spreads a high-risk strategy.

Let's look at the worst-case scenario in the Google example above. If shares stabilized around the $625 level, and implied volatility continued the typical post-earnings decline, the position would be worth around a $7 net debit, for a $9 or 56% loss. If it were to be stubbornly held until the May expiration and shares were right at $600, the loss would be a whopping $32 -- far more than the initial $16 outflow.

This type of risk creates a dilemma: Back spreads can usually be established on a more attractive ratio closer to expiration as the further out-of-the-money option becomes less expensive. But holding a back spread until expiration increases the chances it will land in the dead zone and incur a loss.

There are two ways to minimize this possibility.

1. If you establish a back spread with more than two weeks until expiration, only plan on holding until there is at least one week remaining until expiration. If the big move you were expecting doesn't occur, it makes sense to just get out.

2. If the stock moves opposite your prediction, as in higher on a put/bear back spread, think about buying back the short portion of the position as a decrease in value also creates a less attractive risk/reward for remaining short it. Remain long the out-of-the-money strikes at a lower effective cost basis. Many times, these seemingly worthless options can come back to life and produce big profits.

Back spreads can be powerfully profitable, but they must be used judicially and traded around nimbly.

For more from Steve Smith, take a FREE 14-day trial to OptionSmith and get his specific options trades emailed to you along with exclusive access to his full portfolio. Learn more.

Here is a complete schedule for "9 Weeks to Better Options Trading":

Week 1: 5 Rookie Mistakes Options Traders Make

Week 2: Option Pricing Basics: Understanding Implied Volatility and Time Decay

Week 3: Trading Strategy: The Power of Calendar Spreads

Week 4: Trading Strategy: Butterfly Spreads

Week 5: Trading Strategy: Iron Condors

Week 6: Trading Strategy: Risk Reversals

Week 7: Trading Strategy: Back Spreads

Week 8: Managing Risk

Week 9: Special Situations: Earnings Reports, Takeovers, and Extreme Market Moves
No positions in stocks mentioned.

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.

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