A Picture is Worth a Thousand Words

Russ Allen

That is a familiar saying. In this article, you get both!

Last week I wrote about a backspread. This is a strategy that can be used to profit when we expect a large price move, are unsure or neutral as to that move’s direction, and expect a sizeable increase in Implied Volatility (IV). The backspread is an alternative to Straddles and Strangles, which can also be used when those are our expectations.

The backspread is usually cheaper and less risky than the other two. The tradeoff is that its profit is unlimited in one direction only, and limited in the other. Straddles and strangles have unlimited profit in both directions. But they have less chance of making a profit in the first place.

Our example is XLF, the financial sector ETF. It was at exactly $16.00 on December 14, 2012, with a multi-year low IV reading of 17%.  For our backspread, we looked at buying 3 March 16 puts at $.63, and simultaneously selling 2 March 17 puts at $1.27. The cost was 3 times $63, minus 2 times $127, for a net credit (money we were paid to do the trade) of $65.

Like any strategy where we receive a credit, we don’t necessarily get to keep all of it.  We would have to pay it back, and then some, if our expectations prove incorrect by too much.  In this case, our worst outcome would occur if we held the position until the March expiration, and XLF stayed at exactly $16. In that case our three long 16-strike puts would be worthless, while our two short 17-strike puts would be worth $100 each. We’d have to pay out that $200.  Since we had earlier collected a $65 credit, our net loss would be $135. Because of that possibility, our broker would require $135 of our money in margin to do the trade.

Looking at happier possibilities, we believe that the price of XLF will not stay at $16. If XLF moves down from $16 our position profits from the increase in value of our three long 16-strike puts. The farther XLF moves down, the more valuable they’ll be. Although the 17-strike puts that we’re short will also be increasing in value, which hurts us, there are only two of them. There are three of the 16-strike puts helping us. The net result is that for every dollar XLF moves down from $16, our position becomes more valuable (i.e. better than the $135 maximum loss) by $100. Our profit is (almost) unlimited to the downside.  Best case for us is if XLF goes to zero. In that case our three 16-strike puts would be worth $1600 each. Meanwhile our two short 17 puts would be worth $1700 each.  Our net position value would be (3 X $1600) minus (2 X $1700), or ($4800 – $3400) = $1400. Adding in the original $65 credit, that would be $1465 in profit on a risk of $135. Not bad.

We don’t actually expect to make the maximum profit, and in fact that’s virtually impossible. XLF is an ETF which follows an index (the Financial Select Sector Index). If even one of that index’s constituent stocks became worthless, it would be replaced in the index by the stock of another company in the financial sector. The index can not go to zero, as long as there are any public companies left in business in that sector. The only conceivable way that XLF could become worthless is if it was discovered that there was massive fraud on the part of the custodial bank that holds the stocks that back the ETF, and that all the money had disappeared. Hmmm. Maybe not impossible, come to think of it. But it is unlikely.

Anyway, fortunately we don’t need the ETF to go to zero to make a profit. A move down to $16.00 minus $1.35 will do the trick. That $1.35 is our maximum loss per share, as described above. So below $14.65, we make money.

If the direction of XLF’s price move is up, our profit comes from the drop in value of our short $17 puts. At any XLF price above $17 at expiration, those puts would be worthless. So would our long $16 puts. All that would be left would be the $65 original credit in our account, which we’d get to keep.

Now a twist – all the above assumes that we keep the position until expiration. But that’s not what we plan to do. A big part of our plan was to profit from an increase in Implied Volatility. IV is irrelevant when there is no time left (at expiration), since IV only affects time value. The only way to profit from an increase in IV is to sell long options while they still have time value – that is, before expiration.

This is the reason that we selected the March puts instead of a nearer expiration. We want there to be lots of time left when/if the IV increases. That way, the increased IV will pump air into the options, which we can then sell for a bigger profit. That air is escaping through the slow leak of time decay, so we want to get rid of this tire long before it goes flat. We plan to hold on to this position for about a month, and then sell it while it still has two months of time value left.

Figure one below shows the amount of profit or loss this position would make at any nearby price of XLF. The green straight lines show Profit or Loss if the position were held until the March expiration. The curved lines show what the P/L would be if the position were closed out on January 18, two months before expiration. There are three curved lines, representing three separate possible IV scenarios.

rallen 20130115_Fig1

Notice that at XLF prices below about $17, the higher IV is, the better off we are. In that range we make more money at 22% IV than at 17%, and more still at 30%.

We can also clearly see that although this position can make money at either high or low prices, its profile is quite different on each side. At high XLF prices, increasing IV stops helping us, while at low prices it never does.

Also, any time the curved line is above the green straight line, we are long time value, and therefore we have positive vega and negative theta. IV helps us, time hurts us. But at prices where the curved line is below the green straight line, we are short time value, and therefore we have negative vega and positive theta. At those prices, rising IV hurts us, and further time passage helps us.

The changing effects of IV and time at different prices are clearly shown by the diagram once we really study it. It’s pretty subtle, but being able to visualize it in this way makes all the difference in picking the right strategy for our price and IV expectations. And that’s what it’s all about.

For comments or questions on this article, contact me at rallen@tradingacademy.com.

This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.