Since we are buying extra options ,the strategy has a limited risk profile.
Nifty has been approaching new all-time highs and with indices possibly ending its consolidation there may be many fast-moving opportunities in either direction for many stocks. The fast moves can be well leveraged without even taking an un-limited risk using Backspreads. Let us understand how to create backspreads and its pros and cons.
What are Backspreads?
Backspreads are strategies where one typically sells an ATM strike option and buys 2 lots of OTM strike options. If the view is bullish the same can be created with calls and for a bearish view puts can be used. Backspreads can also be created by selling ITM options and buying OTM options.
The ratio of selling to buying could be any number but 1:2 is generally preferred. This strategy can have net premium outflow or in some cases may not have an outflow at all. Though, one should avoid buying too far OTM options as the probability of profit will also diminish in reality.
A good thing about backspreads is that, since we are buying extra options ,the strategy has a limited risk profile. But, the upside is unlimited. In terms of Option Greeks, there are two risk factors: Delta & Theta.
Delta: is when the underlying goes inverse to the direction of forecast. The delta risk can be reduced if the strategy did not have enough premium outflow or in some cases one might have a premium inflow.
Theta: If there was a net premium outflow then theta is a risk as the premiums will decay but again if the outflow was limited this risk is also low.
When to execute?
Typically, backspreads can have minor premium outflows and the net strategy could be negative theta. Theta decays the lowest in the first half of the expiry and this is the best time to execute backspreads.
A holding period of maximum 2-3 days is generally targeted. Holding the strategy more than this time frame can diminish the odds of making profits due to theta decay.
Since the net strategy has extra options bought, a big move in the expected direction and within a short time period, can provide a healthy return profile. The strategy is leveraged compared to just buying a single option where one is confident of the trend and the forecast can be converted into a high reward to risk profile.
When to avoid the strategy?
The strategy should not be initiated in the second half of the expiry if there is a net premium outflow which can accelerate theta decay leading to a lower reward to risk profile. The strategy should also be avoided when there are known events like corporate results, monetary policy, fiscal policy, etc.
The strategy has a positive Vega exposure and if there is a drop in implied volatility after the event, this can lead to reduction in net premium and hence should be avoided.
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