Yep. So I guess your ideal scenario would be a Black Friday type event. Well, maybe not your ideal scenario, but you would make a pretty hefty profit if markets dropped 25% and the VIX went to 90.
<<< Downside, well, you could hold onto short positions 'til the bitter end and risk a max loss, this would be very irresponsible right? After all, this trade does ultimately have the the same max loss as an iron condor. If the market is coming after your shorts, well, you have to adjust, which means you will eat into your credit. There is no holy grail, I think even a novice can figure that out. The trade set up from the beginning is safe but the holding period can be long. By the way, this is how I like to trade but this is likely not for you. You should stress test your own trades and trades like the back ratios that I have talked about.>>> You are correct. It is not something that appeals to me. I was asking for the other trader who asked the question. The back ratios you discussed are something I would consider. Thanks for your reply.
this is a strategy i've been touting for a while.. i'm glad someone is finally listening.. thanks Hedgeman.. this is actually a liquidity function strategy for market makers as well.. obviuosly if they are getting a little better action on the bid and asks they have an advantage then us.. if your wrangling like this your short the 2 standard deviation moves.. or there of so called "more normal" moves of the market.. and your long the crash.. My experience is.. you either get a swift move past your strikes.. or the trade can drift down and put you in trouble.. i've only experienced closs to the max loss on this backspread strategy once..
I agree, when you stress test a similar trade by adding vol, even 10 points, you can see clearly that backratios are winners. So, if you wake up one day and you have a financial disaster and futures down heavy, you don't have to panic. Over time the trade changes obviously, so you will have to maintain the safety on the trade both directions.
The ratio should be determined by the expected slope of the skew if underlying hits your short strike and time to expiry. The ratio is typically higher for calls because of the skew. For put backspread the slope will hardly change if underlying gaps down. But it's a different story for calls. You might buy calls when local slope is slightly positive but when underlying gaps up the slope will turn negative and your long calls vol will now be a lot lower that the vol of short calls. That's why you need higher ratio for calls. The closer you get to expiry the higher ratio you will want to put on. This is because the difference in vega and gamma of long and short legs widens which makes your long leg less sensitive to vol and delta but the short leg gets riskier. A simple approach to get the expected slope of the skew if underlying hits your short strike is to look at current slope and greeks of ATM options, they will give you some estimate.
higher ratio meaning? 1 short call 3 long calls.. as oppose to 1x2 i'm not sure how one adjusts these trades if the underlying starts getting friendly with your short strike..
Yes, more longs for each short for calls than you would need for puts. I would roll the backspread to a lower gamma/vega strike as adjustment. Another option is to close some longs for a profit if you believe the underlying will come back where it was.
Adjustments or additional trades is a topic in and of itself. I like to start with a 1/2 or 1/3 postion then just add to the trade so the adjustments are already baked in. If you were adjusting the call side, its likely you would have a put side profit, so you could buy back the short puts and roll fewer of them up a bit closer to the money for additional credit, then you could either buy back some short calls or spreads or do a butterfly roll, among other things. Don't forget, these back ratios will have the same risk as standard credit spreads over time and thats why it is not wise to be sitting in these trades or any as expiration nears. This is how you can lose big and why a lot of traders get lit up.