How to Use Option Back Spreads to Trade Stocks with Less Money

By Todd Vukovich, trader, SMB Capital

The goal of my articles is to teach traders about options. I started trading stock options back in 1985, making markets on the floor of the CBOE. The changes over the past 25 years in some ways are good, while others bad. My views come from looking from the floor outward. Computers have sped up the process, but the game hasn’t changed much. I moved off the floor in 2002, as did many others. If the SPX pit weren’t there, the floor would make a nice indoor parking garage.

My philosophy in ways is contrary since I was taking the opposite side of the trade (position not deltas). Most of the time I was always long extra units (options) in my book. The times that I was net short units seemed to always cost me huge. I’d rather know what I can lose than not know the possible losses. There were many floor traders who took the opposite view and were always short premium and/or volatility and were successful. I just couldn’t trade that way and sleep at night. Over my career on the floor, I carried limit positions sometimes, but also traded small (five or ten lots).

My trading style did change a bit from the floor. Since your position is always changing while market making, it was difficult to keep one on, but off floor (since I’m not making markets), putting one on is easy. Over time I will present some old ways and techniques of trading that compliments current ideas. I compare it to using a calculator. One should know that 2+2=4 and how the process was derived, rather than just plugging it into the calculator and assuming its right. In some ways, the speed can be dangerous, as we saw on May 6, the day of the “flash crash.”

I will also discuss insights and experiences along with some very funny, and in some cases, sad stories. The first area that will be discussed is the back spread. Currently, I think the market is at an important inflection point, meaning the market is about to move big!

The Back Spread

What is a back spread? It is when a trader uses an option and trades stock around the option position. In this example, we will keep it simple and just use one strike price against stock.

The main thesis behind a back spread is either volatility will increase, or the intraday stock movement will pay for the daily Theta (decay). Everyday options decay and the rate in which they decay is called theta. Theta is a very important component in determining how much it costs per day to trade the position.

If an option has a decay rate of .017 per option, owning ten contracts would theoretically lose $17 per day assuming all other variables remain constant. In the example below, the following data is known:

Home Depot (HD): Stock price $29.85; September 30 call .39; Theta .017; Gamma .34; Vega .023

Trading days to expiration: 9; Delta .46; Assume variables remain constant

A ten-contract position in HD would cost $390 to establish. In this case, we will keep the position delta-neutral, so we sell 460 HD shares short at $29.85. Now the hard part is determining when to adjust the position. Gamma tells us that if the shares move up one point, our previous delta-neutral position is now 46 deltas long (assuming variables are constant). Selling 46 shares at 30.85 would then re-establish a neutral position, leaving the position short 506 shares versus long ten September 30 calls.

After the one-point rally, the stock fades and quickly drops half a point. At this time, we buy back 23 shares at 30.35. Later in the day, the stock falls back to unchanged, and keeping with our desire to stay delta-neutral, we buy another 23 shares at $29.85.

The end result: We scalped 23 shares, making one point, or $23, and the other scalp was 23 shares for half a point, or $11.50, netting a total of $34.50 profit on the stock side. However, on the option side, the ten-lot position decayed $17 on the day, resulting in a profit of $17.50.

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The above example is a very simple one, as there are other variables that don’t remain constant in the real world. Also, in the example, the stock made a fantastic move. One of the hardest choices is determining when to adjust the deltas. Overadjusting say every 25 cents in the above example would have turned a winning day into a losing one. Below is adjusting every .25.

Sold 11 shares $30.10; bought back 11 $29.85; net $2.75
Sold 12 shares $30.35; bought back 12 $30.10; net $3.00
Sold 11 shares $30.60; bought back 11 $30.35; net $2.75
Sold 12 shares $30.85; bought back 12 $30.60; net $3.00

With decay being $17 and buying every .25 move, it resulted in loss of $5.50 (17-11.50).

One can see how when to adjust is a key factor in making a move a losing or winning day. Adjusting is an art; not a science. We will get into other factors to determine when to adjust, but getting back to the example, let’s discuss how theta can be affected. The decay of an option is not constant. If there are ten trading days left and the option is trading for $1, it will not decay exactly .10 per day. Weekends create time for something to happen. Assuming no change in volatility, an option will decay at a higher rate as it gets six weeks closer to expiring.

One reason is the odds of the stock moving decreases as the time period decreases. A stock has a better chance to move five points over 50 days than it does in five days.

Theta changes if volatility changes. The higher the volatility, the higher the price of the option, resulting in higher daily decay. Conversely, as volatility drops, the price of the option declines, and so will the daily decay. Besides theta, one should realize not only do we need to trade the gamma in such a way to make the daily decay, but a change in volatility will either help or hurt theta. One can be wrong on the adjustment of deltas on one hand, and on the other, make it up if volatility pops. In the case above, Vega was .023, meaning a one-point increase in volatility will cause the option price to increase 2.3 cents, thus creating higher decay.

Generally, back spreads work better on the downside for a few reasons. Stocks decline at a faster rate than they rise. Even though a stock has more upside than downside (a $30 stock can only go down $30, while the upside is theoretically infinite), people seem to panic out more than they panic into a stock. Usually, a decline in a stock will lead to at least a short-term pop in volatility. Stock rumors can also create volatility pops, but to the upside.

Overall, one can make a lot of money with limited risk by using the back spread strategy. Picking the right stock along with the right option is a key to a successful trade. Let’s take a look at real-life example I will be trading this week.

I’m looking for a stock that is between strikes and FCX fits the criteria. Chart wise, the stock is expected to move away from this level. It should move into the low 80’s or fall to the 73 level.

Click to Enlarge

Here are the stats on FCX (at the time of this writing):

Trading around $78; IV30 – 42; IV on the 80 strike is 39, so cost $1.15 per contract

Gamma .074; Delta -35 Theta -.095; Vega .048; IV360 – 44; HV360- 50; HV10 – 51; HV20 – 44

For example, let’s buy 100 September 80 calls for 1.15, costing $11,500 and short (3500) shares at $77.86 (Easy to show using 100 contracts). The 740 gamma will be adjusted every half point today. At the end of the day, will show the stock trades. Depending on the market, I might trade for .25 during the slow market hours.