Options Blueprint Series: Backspreads as a Portfolio Hedge

1. Introduction

Backspreads are a versatile options strategy as they allow traders to benefit from significant moves in the underlying asset, particularly when there is an expectation of increased volatility.

2. Understanding Backspreads

A backspread is an advanced options strategy involving the sale of a small number of options and the purchase of a larger number of out-of-the-money options. This setup creates a position that benefits from large price movements in the underlying asset.

3. Generic Uses of Backspreads

Backspreads offer traders a flexible tool to capitalize on significant price movements and shifts in market volatility. Here are some common uses:

Market Sentiment Alignment:

• Bullish Sentiment (Call Backspreads): Traders use call backspreads when they expect a significant upward move. This strategy involves selling a smaller number of lower-strike call options and buying a larger number of higher-strike call options.
  
• Bearish Sentiment (Put Backspreads): Conversely, put backspreads are used when traders anticipate a significant downward move. This involves selling a smaller number of higher-strike put options and buying a larger number of lower-strike put options.
  

Volatility Trading:

• Backspreads are particularly useful in trading volatility. They create positions with positive Vega, meaning they benefit from increases in implied volatility. This makes backspreads an excellent choice during times of market uncertainty or expected volatility spikes.
  

4. Hedging an Equity Portfolio using with S&P 500 Futures Put Backspreads

Put backspreads offer an effective way to hedge a long equity portfolio against sharp downward moves. By setting up a put backspread, traders can create a position that not only provides downside protection but also benefits from increased market volatility.

Setting Up a Put Backspread for Hedging:

• Sell 1 OTM Put: The initial step involves selling one out-of-the-money (OTM) put option. This option will generate a premium, which can be used to offset the cost of the puts that will be purchased.
  
• Buy 2 Lower OTM Puts: Next, purchase two lower OTM put options. These options will provide the necessary downside protection. Depending on the strike selected, the cost of these puts will be fully or partially covered by the premium received from selling the higher-strike put.
  

Constructing a Positive Vega Position:

• The structure of the put backspread results in a position with positive Vega. This characteristic is particularly valuable as volatility typically rises during periods of sharp declines.
  
• Risk Profile:
  
• Below is the risk profile of a put backspread used for hedging purposes as described in section #6 below.
  

5. Market Scenarios

Understanding how a put backspread behaves under different market scenarios is crucial for effective trade management and risk mitigation. Here, we explore the potential outcomes:

• Market Moving Up or Staying the Same: Flat P&L
  
• If the market moves up or remains around the current level, the put backspread will likely expire worthless.
  
• Market Moving Down Sharply: Increased Profitability
  
• If the market experiences a sharp decline, the put backspread would potentially become profitable.
  
• Impact of Increased Volatility: Enhanced Gains
  

A rise in implied volatility benefits the put backspread as higher volatility increases the value of the bought puts more than the sold put, adding to the overall profitability of the strategy.
Maximum Risk and Trade Management:

• Maximum Risk: Limited to the difference between the strike prices minus the net credit received (or plus the net debit paid).
  
• Trade Management: It is essential to actively manage the position.
  

6. Trade Example

To illustrate the application of a put backspread as a hedge, let's consider a detailed trade example using S&P 500 Futures Options.

Trade Rationale:

• Current Market Condition: The S&P 500 Futures have just created a new all-time high, indicating that the market is at a crucial juncture. From this point, the market could either continue its upward trajectory or experience a severe change of direction.
  
• Implied Volatility (VIX): The VIX, which measures the implied volatility of options, is currently very low at 11.99. This low volatility environment makes it an ideal time to enter a backspread, as any future increase in volatility will significantly benefit the position.
  

Trade Setup:

• Underlying Asset: S&P 500 Futures
  
• Current Price: 5447
  
• Strategy: Put Backspread
  
• Expiration Date: December 2024
  

Specifics:

• Sell 1 OTM Put: Sell 1 4600 put option
  
• Buy 2 Lower OTM Puts: Buy 2 4100 put options
  

Entry Price:

• Sell 1 4600 Put: Receive $2,160 premium per contract (43.2 points)
  
• Buy 2 4100 Puts: Pay $1,068.5 premium each; total $2,137 for two contracts (21.37 points x 2)
  

Net Cost:

• The net cost of the backspread is the premium paid for the bought puts minus the premium received from the sold put.
  
• Net Cost: $2,137 (paid) - $2,160 (received) = $23 net credit
  
• As seen below, we are using the CME Group Options Calculator in order to generate fair value prices and Greeks for any options on futures contracts.
  

Maximum Risk:

• 500 – 0.46 = 499.54 points (distance between strike prices minus the net credit received).
  

7. Importance of Risk Management

Risk management is a fundamental aspect of successful trading and investing. It involves identifying, analyzing, and mitigating potential risks to protect capital and maximize returns. When implementing a put backspread as a portfolio hedge, understanding and applying robust risk management practices is crucial.

Using Stop Loss Orders and Hedging Techniques:

• Stop Loss Orders: Placing stop loss orders helps limit potential losses by automatically closing a position when the market reaches a certain price level. This ensures that losses do not exceed a predetermined amount, providing a safety net against adverse market movements.
  
• Hedging Techniques: Utilizing hedging strategies, such as combining put backspreads with other options or futures contracts, can provide additional layers of protection. This approach can help manage risk more effectively by diversifying exposure and reducing the impact of unfavorable market conditions.
  

Importance of Avoiding Undefined Risk Exposure:

• Defined Risk Strategies: Employing strategies with clearly defined risk parameters, such as put backspreads, ensures that potential losses are limited and known in advance. This contrasts with strategies that expose traders to unlimited risk, which can lead to catastrophic losses.
  
• Position Sizing: Properly sizing positions based on risk tolerance and account size is essential. This involves calculating the maximum potential loss and ensuring it aligns with the trader's risk management plan.
  

Precise Entries and Exits:

• Entry Points: Entering trades at optimal levels, based on technical analysis, support and resistance and UFO levels, and market conditions, enhances the probability of success. In the case of put backspreads, entering when volatility is low and market conditions are favorable increases the potential for profitability.
  
• Exit Points: Setting clear exit points, including profit targets and stop loss levels, helps manage risk and lock in gains. Regularly reviewing and adjusting these levels based on market developments ensures that positions remain aligned with the trader's overall strategy.
  

Continuous Monitoring and Adjustment:

• Regular Review: Continuously monitoring market conditions, position performance, and risk parameters is essential for effective risk management. This involves staying informed about economic events, market trends, and changes in volatility.
  
• Adjustments: Making timely adjustments to positions, such as rolling options, adjusting stop loss levels, or hedging with additional instruments, helps manage risk dynamically and adapt to changing market conditions.
  

By incorporating these risk management practices, traders can effectively use put backspreads to hedge their portfolios and protect against significant market downturns.

8. Conclusion

In summary, put backspreads offer a powerful tool for hedging long equity portfolios, especially in low volatility environments and/or when markets are at all-time highs. By understanding the mechanics of put backspreads, their application in various market scenarios, and the importance of active risk management, traders can enhance their ability to protect their investments and capitalize on market opportunities.

When charting futures, the data provided could be delayed. Traders working with the ticker symbols discussed in this idea may prefer to use CME Group real-time data plan on TradingView: www.tradingview.com/cme. This consideration is particularly important for shorter-term traders, whereas it may be less critical for those focused on longer-term trading strategies.

General Disclaimer:
The trade ideas presented herein are solely for illustrative purposes forming a part of a case study intended to demonstrate key principles in risk management within the context of the specific market scenarios discussed. These ideas are not to be interpreted as investment recommendations or financial advice. They do not endorse or promote any specific trading strategies, financial products, or services. The information provided is based on data believed to be reliable; however, its accuracy or completeness cannot be guaranteed. Trading in financial markets involves risks, including the potential loss of principal. Each individual should conduct their own research and consult with professional financial advisors before making any investment decisions. The author or publisher of this content bears no responsibility for any actions taken based on the information provided or for any resultant financial or other losses.