Backspread a de facto free hedge if you are short?

Discussion in 'Options' started by mokwit, Jan 16, 2008.

  1. Not familiar with the ins and outs of options strategies and how behave under different conditions so need to ask here

    I am long a portfolio of naked puts (i.e have bought puts) with maturities from March to Jan 09 with the bulk around June and confident that long term the direction is down within that timeframe. Some are deep ITM some ATM some mildly OTM.

    I am thinking that if I established an entirely seperate call backspread i.e using index options such as QQQ or NQ (i.e not with the individual portfolio positions) large enough to hedge that portfolio and there was a major, but temporary rally I could be hedged against that and stand to profit by the credit taken (or not lose call premium paid) when the rally ended and also would be able to establish this position with little incremental margin requirement. I would have some protection against a rally that could cause the March puts for example to expire OTM and this would make the hedge worth doing rather than just riding out the rally knowing my risk was the put premium. Last but not least, I would also stand to profit rather than lose a lot of premium paid on puts for limited further outlay if my bearsih call was just plain wrong. I realise if the market went nowhere I could lose some amount related to the difference between the Call sold and calls bought (not sure exactly how much).

    Am I missing or duplicating something here?

    Simple language please - assume knowledge is general Finance degree/ able to understand most of what I read in Natenberg/Macmillan.

    Answers before Bennie the Clown cuts 100BP between meetings on option expiry day appreciated:D
  2. This is an challenging puzzle that's tough to specifically answer because there are so many variables involved and possible results. Here are some considerations but in the last analysis, you're going to have to put the pieces together and act accordingly.

    On the equity side, you have a variety of stocks with different implied volatilities as well as long puts with different degrees of ITM vs OTM. So with subsequent underlying price change, you are going to see a variety of results, some better, some worse. Plus you have time decay working against you.

    Odds are, they are going to be higher IV stocks than your index. With a Bennie the Clown event, all will react differently. So I think that it's going to be tough to do anything better than a guess at the results.

    Now on to call backspreads. How well they hedge/perform will depend on how far OTM they are, what strikes are involved, when the move occurs, what ratio you use (simple -2/+1 ?), what their subsequent IV is. If the market rallies immediately, they will lose immediately. If their IV increases immediately, they will lose immediately. If their IV increase post Bennie event and the market rises, you'll never see a penny of profit from them. Possibly an unrecoverable loss.

    So I would not assume that if there was a major, but temporary rally you would be hedged against loss of put value/premium. I would not assume that you would stand to profit by the credit taken (or not lose call premium paid) when the rally ended. It's possible but it's not a guarantee. Every option position has an area of risk - well, at least directional ones do.

    I would not assume that you would have some protection against a rally that could cause your March puts for example to expire OTM and this would make the hedge worth doing rather than just riding out the rally knowing my risk was the put premium.

    It is possible that the backspreads could protect if IV doesn't increase (or contracts) and there's a modest but not sustained rally. But I just don't see them as a good bet because there are many unknowns and they add another layer of risk to you position. One thing is for sure, they are not a de facto free hedge if you are short.

    I would suggest that you use a position model and input some possible backspread positions. Consider various strikes and expirations and model what the results are at various prices and various IV's. Then contemplate whether the performance that you see on those risk graphs is a suitable counter balance for what you perceive to be your current long put exposure.

    You mentioned that some of your long puts are deep ITM. With those, I would consider taking more aggressive action. I assume that if they're deep ITM, you have decent profits on them. If so and if you're still bearish on them, consider rolling them down so that you are booking profits and go forward betting with other people's money (OPM). Yes, you'll be rolling to a lower delta and yes you won't make as much if the underlying continues down, but you won't give up those profits if that stock rallies. A bird in the hand.... ?

    Another possibility for the deep ITM's would be to buy a cheap OTM call that locks in some of your gain yet allows you to participate in a future move, regardless of where the stock goes. For example, with XYZ at 50 you bot a 50 put. If XYZ is is 45 or less, buy acall. A 45 will lock in 5 pts less the net premium paid. You'll own a 45c/50p guts strangle. No matter where the stock goes, you'll make that net credit and possibly more.

    Another possibility would be to close the very profitable deep ITM long puts and buy puts on other stocks that you're bearish on. Book the profit and bet elsewhere.

    And even another possibility is to convert your profitable long puts to verticals. Sell premium to recover the initial premium laid out to buy them - particularly if you can convert to free trades (net credit). Bet with OPM.

    There are an infinite number of possibilities. Perhaps it might be best to take a macro approach and add up you total long delta and hedge accordingly. That's probably a good idea for someone far more sophisticated than me and IMHO, that would still be a bit of a crap shoot because of so many underlyings, variable and even a question of correlation.

    My two cents is that I would focus on defending your most profitable positions, booking and/or locking in profits. I believe that pulling money, especially profits, off the table is always a good idea.

    Sorry that this got so long in the tooth. Fortunately for you, the reg. market opens in a few minutes and I have to suit up for the ball game. I hope that this topic generates some participation. It's an interestng one...

    Good luck
  3. Nanook


    Call Backspread is long more: -1/+2

    Ratio spread is short more: +1/-2
  4. Oops, thanks for catching that. Was rushing to finish reply B4 market opened and brain farted :)
  5. One man's backspread is another man's ratio-spread.
  6. The convention is to refer to the -1/+2 as a long backspread. Short the backspread at +1/-2. The position would dissect to a replicated long strangle, short call:

    Long otm index calls
    Long otm component puts [legacy position]

    Short atm index call

    You would structure the backspread otm calls roughly equal $vega your component puts. Then simply solve for the 2:1 ratio [favoring otm calls] to arrive at the number of short atm calls. The risk is convergence to the strike under reduced vol. Obviously vols will contract on any rally. I'd be very careful here with long duration vega.

    You can afford to spend some of those put vegas in a long risk-reversal. Long otm calls/short otm puts in NDX.
  7. It may feel better for you if you initiate the backspread at breakeven or a credit. It ought to work better on higher-growth stocks whose implied volatility rallies with the price advance, not slower-growth issues that behave contrarily.
  8. Thanks to all for responses will take a while to get my head round every point made but what is immediately clear is that I am not paying enough attention to how current peak volatilities can make or break an options spread.
  9. Today I'm going to try a shorter answer w/o the brain fart :)

    If Bennie cuts and the market likes his act, IV is likely to contract. That will hurt your long puts. That's not likely to help a backspread and the BS will then help only if there's a large enough up move that puts the long calls into play (ITM). OTOH, the status quo of IV means that the directionality of each side gets a better chance to profit. The effectiveness of the BS as a hedge will depend on subsequent IV and price change and even time decay. The last two are easier to perceive than IV change. So as you noted, focus on the effect of IV change on your existing and subsequent hedged position.