Diagonal Backspreads

Mark Wolfinger was a market maker on the floor of the Chicago exchange for years. It s hard to survive on the floor even though you are buying on the bid and selling on the ask. Upstairs we have to buy closer to the ask and sell closer to the bid. Nowadays the spreads have narrowed so even market makers aren’t living lovely like they were.

He knows his way around options and his blog has some interesting posts and discussions. Here he discusses diagonal backspreads as a way to profit from a market move. He wrote these at the end of March when the market was moving up. It is something to keep in mind if the market ever breaks out of its range and moves down (or up some more).

In Back Spreads Standard and Diagonal he talks about the risks of a credit spread. Say you sell XYZ June 90 and buy XYZ June 100 calls. If XYZ is trading at 92, you can do that for a credit. The risk is that XYZ finishes somewhere between 93, say, and 100 where the calls you sold are more expensive and the calls you bought, the 100s have no value.

In a backspread you sell 10 XYZ June 90s and buy 15 XYZ June 100s. Here you might be able to collect a small premium, which if XYZ goes the wrong way, down, would be your profit. If XYZ moves past 100 those five extra calls give you unlimited upside. Again, if XYZ finishes below 100 your long calls are worthless and your short calls could put you in the hole for $1,000 each.

In the next installment of our saga Back Spreads Standard and Diagonal II he takes as an example the Russell 2000, RUT, which was at 429 at the time. The diagonal constructed is sell 10 May 460 Calls @ 16.70 with a delta = – 363
and buy 16 June 500 Calls @ 11.70 with a delta – 369. So this is delta neutral initially.

This might help you to follow his discussion.

One way to look at this is as a calendar spread of -10 May 460 Calls/ +10 June 460 calls; and a backspread in June -10 June 460 calls / + 16 June 500 calls. We have just added and subtracted the 10 June 460 calls. The calendar spread does well if implied volatility increases and the June backspread does well if the stock rises rapidly to overcome the drag of time decay and decline of implied volatility which usually accompanies rising stock price.

You can triangulate the position the other way too. That is, it is equivalent to a May backspread -10 May 460 Calls / + 16 May 500 Calls and a calendar spread -16 May 500 Calls / +16 June 500 Calls. The backspread wants a move clear through 500 or not to reach 460 and the calendar spread wants an increase in implied volatility.

The last in the series Back Spreads Standard and Diagonal III shows the return graphs with the effect of changes in implied volatility. It doesn’t show the effect of time decay which would give a surface. Worth reading.