An Option Strategy for a Market at a Crossroads

The stock market has enjoyed a nearly unprecedented rebound from the February lows, gaining some 13.4% over a six-week period. This was the second longest and largest uninterrupted rally in the last 75 years. But nearly all the major indices find themselves at a critical juncture from both a fundamental standpoint and in technical terms.

As we enter the reporting season for first quarter earnings policy makers and investors alike will be looking for signs as to whether the economy is in danger of losing whatever little momentum it has and slipping into a recession. So far, signs suggest corporations are struggling to generate any top line revenue growth. After years of cost cutting, wages are finally creeping higher even as productivity gains are diminishing, meaning profit margins are coming under pressure. If earnings growth remains flat with the S&P 500 at 18.2x next earnings, it will likely be expensive on a historical basis, even with near zero interest rates.

From a technical perspective, if the market cannot punch higher within the next few weeks it will seem to confirm a large top is in place and the seven year long bull market is at an end. If that is the case one can presume new lows will be made in coming months.

SPY chart 3.28.16

I’m not trying to call a top or predict a decline but I do want to have some downside exposure, for both protection and profit, in case the market does roll over. I just don’t want to spend a lot of money on put options and watch that premium waste away if the market turns back higher.

That’s why I’m employing a strategy called a back spread, or sometimes referred to as a ratio-back spread.

More for Less

A back spread consists of all calls or all puts with the same expiration in which one sells a closer-to-the-money strike and buys a multiple number of contracts in a further out-of-the-money strike. The goal is to have as minimal an outlay or debit as possible while achieving the highest ratio of long option contracts to short.

The goal of a back spread is to buy as many options as possible relative to the number sold for the lowest cost. A good rule of thumb would be to buy 3 contracts for every 1 sold for even money. Of course, width between strike prices is one the determining factors of what ratio can be accomplished.

Not to get to wonky but being “net long” the number of contracts you own will translate into giving the position a positive gamma. This means delta increases as price moves in your direction. To put it simply; a bullish position gets longer or more bullish as the price rises. A bearish back spread gets shorter or more bearish as price declines.

Another feature of the back spread is that it benefits from the increase in implied volatility that typically accompanies a sharp decline. This is why I tend to like to this strategy on puts during periods of relatively low volatility levels. And as we can see from the VIX we are near the baseline levels of how low volatility can go.

VIX 032416

SPY a Back Spread

With the SPDR 500 (SPY) currently trading at $204 and the VIX sitting near multi-year lows I can create a low cost position that will stand to benefit if the market tumbles back to the $180 level or lower within the next month or two.

The position I’m looking to establish consists of:

-Buy 3 contracts of May $192 Puts

-Sell 1 contract of May $200 Put

For $1.50 Net DEBIT for the 3×1 spread.

Here is risk graph of the position. As you can see profits accelerate the farther the SPY falls.

SPY back spread risk 3.27.16

Also note, should a price decline come in the form of a very fast sell-off the profits will be even larger. That’s because a sharp decline will be accompanied by a spike in implied volatility, which will cause the value of the out-of-the-money puts you own to increase at a faster rate than the fewer in-the-money calls you are short.

The Dead Zone

The drawback is there’s a moderate decline that could lead to some steep losses. That is if SPY only drifts lower and is at between $192 and $200 on the expiration, it would leave the $200 put we are short in-the-the-money and the $192 put we own near worthless. The worst case is if shares are at $192 on expiration. I’ve marked off this ‘dead zone’ by the blue box.

But also note, if shares move lower prior to expiration profits can be realized. I’ve highlighted the thin line which represents ‘current’ p/l.

Two ways to avoid ending up in this dead zone are:

Close out the position at least a week prior to expiration if shares are near or below the short strike.

Or if the stock moves opposite your prediction, as in higher in this case, buy to close the short put. Remain long the out-of-the-money strikes at a discounted effective cost basis. Many times these seemingly worthless options can come back to life and produce big profits.

Back spreads are powerful positions but they must be used judicially and traded around nimbly.

— Steve Smith

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About the Author: Steve Smith