Wrapping Up On Backspreads

My last few articles have been about Backspreads. Today I’ll wrap that up so we can move on to other strategies. I’ve also been using the backspread example to illustrate how payoff diagrams help us to analyze option positions.

Quick review: On 12/14/12 XLF was at $16.00, and we thought it would move away from there, but were not sure of the direction. We also thought that Implied Volatility was likely to increase. We entered a Put Backspread, by Buying to Open three March 16-strike March puts at $.63 (cost 3 X $63.00 = $189.00); and Selling to Open two 17-strike March puts at $1.27 (credit to us on this leg of 2 X $127.00 = $254.00). Net cash flow was a credit (money in) of $65.00.

The plan was to hold these three-month options for about one month. That time came as of the January expiration on January 18. How did this position do?

Figure 1 below shows the position as we originally graphed it on 12/14/12. The graph was done as of a future date at that time: January 18, 2013. That was five weeks after the entry date. We planned to consider closing out the position then, while there was still two months of time value left in the March options used here. The curved lines in Figure 1 show what the January 18 profit would have been at three different Implied Volatility levels. I selected 17% because it was the IV as of 12/14. I also plotted lines at 22% (a recent level that seemed attainable) and 30% (the high end of expected IV based on XLF’s IV history). All these lines are easily plotted as of any date and volatility level within the TradeStation platform, or other good option trading platforms.

Figure 2 below shows one additional line. The red curved line was the actual P/L curve at the close on January 18. Note that it doesn’t exactly coincide with any of the three original lines. That’s because the IV was not 17% or 22% or 30%. In fact it was about 19%. The actual closing price of XLF on that day was $17.15. The red arrow points to this curve at that price. Notice that the actual open profit was $27.

Here’s how the profit occurred. We originally bought 3 March 16-strike puts at a price of $.63. As of January 18 these puts were at $.14. This represented a loss of ($.63 – $.14) * 3 X 100 = $147.00.

We also sold 2 March 17-strike puts at a price of $1.27. As of January 18 these were at $.40. This represented a profit of ($1.27 – $.40) X 2 X 100 = $174.00.

Net result: gained $174 on the 17 puts and lost $147 on the 16 puts, for a net profit of ($174 – $147) = $27.00. This was on an original investment of $135. So our profit was exactly 20% in 35 days, which works out to 208% annualized. Not the best we could have hoped for, but not too bad.

Note something interesting about figure 2. At the January 18 price of $17.15, the red curved line is below the straight green line (which represents P/L at the March expiration date). This means that at this price ($17.15) we would have more profit later than we have now. In other words, if we did not close out this position now, from here on time decay would actually help us, instead of hurting us, as it was doing when the price was $16.00.

This is because of a predictable change in the relationship between options that are in-, at-, and out-of-the-money. At-the-money (ATM) options always have more time value than out-of-the-money (OTM) options. This is pretty obvious and easy to understand. But ATM options also have more time value than in-the-money (ITM) options. Even though ITM options are more expensive than ATM options, the ITM options have less time value. Much more of the value of ITM options is intrinsic value. The more deeply an option is ITM, the more expensive it is, yet the less time value it has. Options that are very deep in the money will have no time value at all – they will have a value exactly equal to their intrinsic value. (Both ATM and OTM options on the other hand, have no intrinsic value at all, and nothing but time value). At-the-Money options have the most time value of all. They lose time value when the price moves away from their strike in either direction. If price movement makes them move further into the money, the time value they lose will be more than made up for by a larger gain in intrinsic value, and the option becomes more valuable. If price moves the other way, they just get cheaper.

As an underlying’s price changes, it moves past various option strike prices. So an option that was ATM will become ITM or OTM, etc. Later the price might move back and make the original option ATM again.

In our example the 16-strike puts that we bought when XLF was at $16.00 were ATM. The entirety of their $.63 price was made up of time value. The 17-strike puts we sold at $1.27 had intrinsic value equal to (strike price – stock price) = ($17.00 – $16.00) = $1.00. Their time value was (premium – intrinsic value) = ($1.27 – $1.00) = $.27. So we bought time value equal to (3 X 100 X $.63) = $189.00. We also sold time value of (2 X 100 X $.27) = $54.00. Overall we were long ($189.00 – $54.00) = $135.00 of time value. Since we were long time value, time decay was eating away at our position, although slowly. We expected XLF’s price to move, or its volatility to increase, enough to more than offset the time decay.

A month later, with XLF now at $17.15, our $16.00 long puts are no longer ATM – they are now pretty far OTM. They have lost most of their value, and have only $.14 of their original $.63 left. The short $17.00 have gone from being ITM by $1.00, to being slightly OTM. As a result, even though the 17s are worth much less at $.40 (out of an original $1.27), that entire $.40 value is time value – they have lost all their intrinsic value.

As of now, we are short time value, in an amount equal to (time value in short options – time value in long options) = (2 X 100 X $.40) – (3 X 100 X $.14) = ($80 – $42) = $38.00. Note that this $38.00 is the difference between our current $27 profit, and the maximum profit to the upside, which is $65.00.

In other words, if we want to get the maximum $65 in upside profit, we would have to wait for time decay to completely consume all the value in all the options.

Finally, look at Figure 3 below. This shows that if we wait another month, our profit at the current price of $17.15 would be only marginally higher. The only way to make much more profit on this position than we already have, would be for XLF to drop down almost to $14.00, which is not likely. Even if we did decide to wait for that, we’d have to sit through watching all of our profit disappear and turn into a loss before it recovered again. Best just to take the $27 and deploy our money on better opportunities.

Using the payoff diagrams allowed us to visualize our possibilities when we set up this trade originally. They then helped us to dynamically evaluate our position as time passed and things changed. Time spent practicing using these diagrams is time well spent.

Learn to Trade Now