The Hindu Business Line : Backspreads: Attractive for discerning traders

Traders are increasingly using options to take a view on the underlying security or market. The problem, however, is that options expire worthless if the underlying does not move enough within the contract expiry.

Several traders, hence, wanted to know if they could set up positions that pay off no matter whether the underlying goes up or down.

This article discusses one such trade set up – backspreads. It shows how to construct the position and why the set up generates positive payoffs so long as the underlying moves in either direction.

It also explains the risks associated with the position.

Initiating trade set up

Suppose a trader holds a view that Reliance Industries will move to Rs 2,700 if it breaks above Rs 2,400. The alternative view is that the stock could decline to Rs 2,100. This view could be typical for a straddle/strangle set up. The objective, however, is to reduce risk if the underlying trades in a range.

Besides, the trader has an upside bias (or downside bias), unlike in a straddle/strangle where the view is neutral. She can, hence, set up a call/put backspread. We assume that the trader shorts one contract of June 2250 calls and buys two contracts of June 2460 calls.

Understanding the set up

Call backspread is a two-leg transaction where the trader shorts a lower strike call and buys higher strike call. Two features make this position somewhat unique. One, the position is set up as a delta-neutral spread.

That is, the delta of the short options equals the delta of the long options. And two, because of delta-neutrality, the trader purchases more contracts of higher strike calls than she shorts the lower strike calls.

Delta is the change in the option value for a one-point change in the underlying.

If a call option has 0.50 delta (also referred to as 50 deltas), it means that the option value will increase (decrease) by 0.50 for a one-point increase (decrease) in the underlying.

The backspread is set up delta-neutral to minimize the risk for small movements in the underlying.

The trader can set up the spread for a net credit. This is because she shorts an ATM (at-the-money) option and buys OTM (out-of-the-money) option.

The June 2250/2450 backspread can be set up for a net credit of 30 points based on Thursday prices, not including brokerage commissions.

If the stock moves to Rs 2,700 by, say, June 23, the 2250 strike will be worth 450 points (rounded off) with minimal time-value. The June 2460 strike will then be worth 240 points for a total of 480 points.

The trader, hence, receives 30 points on closing the position. This coupled with another 30 points on initiation gives the trader a total gain of 60 points.

Payoffs

But what if the stock instead moves to, say, Rs 2,100? Both the June 2250 and June 2460 calls will expire worthless and the trader nets 30 points- the premium collected on initiating the position.

Suppose the stock trades at Rs 2,350 at expiry.

The June 2250 will carry an intrinsic value of 100 points (2350 minus 2250) whereas the June 2460 will expire worthless.

The net loss will then be 100 points less 30 points collected on initiation.

Conclusion

Backspread differs from straddle/strangle in that it is delta-neutral and is typically set up as a net-credit spread. The flip side is that the position is subject to high risk when the stock trades between the break-even point and the long-strike option.

In the above example, the position will suffer large losses if the stock trades above Rs 2,280 (Rs 2,250 plus 30 points premium) but below Rs 2,460 at expiry. Besides, the position is sensitive to change in volatility (vega).

It would be optimal to set up backspreads when the implied volatility is low. The trade set up is suitable for discerning option traders considering the associated risks.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investor-learning solutions. He can be reached at enhancek@gmail.com)

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