A Possible Trade for Volatile Markets: Back Spreads in BAC

(Editors Note: Brian got us this commentary last Friday, we’re just posting it now).

In light of the recent market volatility caused by a plethora of headlines, I thought it may be the time to chat once again about the back spread options strategy. Back spreads in general can work well in times of volatility, if you are right on your forecast and implied volatility increases after the play is established, that’s the best-case scenario for this strategy.

With that said, recently the VIX index has broken down below the 25 level on a market rally around some positive news regarding the European debt crisis. Many of the indexes that track the banking stocks in the US received a jump up in price.

One of the more volatile stocks in the banking sector is Bank of America (BAC, YTD high 15.28, Low 5.13). For the sake of the argument, let’s say you are taking a bullish outlook for the banking industry before year end. With that in mind, what type of a back spread might one do? For simplicity’s sake, we will use calls to be bullish and puts to be bearish. (That said, keep in mind: this example is for illustrative and educational purposes only. It’s not to be taken as a recommendation to trade without doing your own research first.)

BAC’s stock price is at 7.30
Sell 1 BAC Dec 7 Call @ 0.70
Buy 2 BAC Dec 8 Call @ 0.27
Net Credit 0.16

TradeKing commission $6.90

At expiration (50 days away):
Max Risk: 1 – 0.16 = 0.87
Max Gain: Unlimited

Let’s put this trade into the Profit and Loss calculator on the TradeKing site and study the good news and the bad news that goes along with this strategy. Note: the blue line is the profit and loss as of the day of this writing; the gold line is the profit and loss at the expiration date of the options.

From this graph it shows this strategy expects a big move upwards in the stock, but may be profitable if you are wrong and it goes the exact opposite way.

Assuming the stock is at 7.30, the current market price, here’s the good news of this trade:

1) If the trade can be done for a net credit of 16 cents (current bid) to the account, the trade would be profitable if stock finished below the short strike (7) at expiration.

2) If the stocks drifts forward towards the max loss point (8 strike), the trade may remain profitable (all things remaining equal) as long as it is not close to expiration, which is 50 days away in our example.

3) The position has a positive net Vega, which implies in theory if there is a uniform implied volatility increase after the trade is established it will benefit this position.

4) Best case is that the stock takes off. If that happens, there is unlimited upside potential until the expiration date of the options.

Now for the bad news. Assuming the stock is at 7.30, the current market price, the following applies:

1) If held all the way to expiration, the stock needs a large percentage move up just to get to the break even point ($8.84) on the upside.

2) The position has a positive net Vega, which implies in theory if there is a uniform implied volatility decrease after the trade is established it will hurt this position.

3) The position also has a negative net Theta, which implies in theory that every day that passes and the stock does not move time decay will eat away at the profitability of the position.

After discussing the good and bad news with this trade, it is obvious this trade is not for the light of heart. Another thing that is obvious from the gold line on the expiration graph, if the stock is hanging around the 8 strike you do not want to find yourself still in the trade at the expiration day.

If you are bearish you can use puts and the graph would take a 180-degree turn. Here is a similar trade, but with a bearish spin. We will use the same strikes with the puts as we did with the calls to keep things simple.

BAC’s stock price is at 7.30
Buy 2 BAC Dec 7 Put @ 0.42
Sell 1 BAC Dec 8 Put @ 0.96
Net Credit 0.12

Commission $6.90

At expiration (50 days away):
Max Risk: 1 – 0.12 = 0.87
Max Gain: Substantial (stock can only go to zero)

Back spreads are not a simple strategy and are not talked about much in times of low volatility. The markets recently have been bearish and at times bullish, but they have for sure been volatile.