Markets unPACKed: Backspreads into December
Backspreads into December
As we approached Thanksgiving, we made new highs in soybeans, at 1200. However, November ended with the market reversing somewhat. Export numbers began to slip, possible drought concerns in Brazil dissipated as rain came into the forecast, and worsening COVID-19 rates lead to ethanol consumption concerns weighing on the grain complex.
At Pack Creek Capital, we look at fundamental and technical analysis in relation to trading strategy. Both the technicals and the fundamentals must align for us to take a position in the market and execute.
In this blog, we are going to look at a strategy we focused on in relation to these indicators. We will not always dive into both fundamentals and technicals, but we will publish which indicators our team is most focused on that led to the strategy being adopted. We want this to be an inside look at our process — to inform, educate, and demonstrate our decisions as risk managers.
The demand market we’ve seen through the fall is diminishing, in our view, leading our team to put on bearish trades.
One trade that we have used through 2020 is the 1×2 Backspread with Puts — also known as Ratio Volatility Spread. We will refer to it as a backspread. Below is a hypothetical example and description.
- Sell a put, strike price B
- Buy two puts, strike price A
- Generally, the underlying futures will be at or around strike price B
- Strike price A will be lower than strike price B
On November 27, soybeans opened slightly higher and the volatility skew of February options showed there were still more call buyers than put buyers. So, puts would be a little cheaper; if one is bearish, it is a good time to take advantage of cheaper premium.
We focused on February options on March futures to give ourselves more time in this trade. Premium concern is lower in this trade, as it is usually entered at a net credit or at break-even; because you have the double quantity of the long side, it tends to be close to even money.
- SH1 opens at 1187’4.
- Sell a put at 1180 at 40c (strike B)
- Buy two puts at 1140 at 18c (strike A)
(prices are hypothetical for the sake of the explanation)
You are selling an at-the-money put in order to help pay for the extra out-of-the-money long put at strike A. Ideally, you want to establish this strategy for a small net credit. Our theoretical trade would be 4c credit.
The further the strikes are apart, the easier it will be to establish the strategy for a credit. However, note that the distance between strike prices also increases your risk, because the futures will have to make a bigger move to the downside to avoid a loss.
By design, the short put loses as the futures contract trades lower, but the two long puts will offset the losses of the short put. Eventually, the position acts like you are short futures if the move to the downside is large enough.
The idea is that if you’re wrong on market direction, and the contract remains above the strike price of the short put (1180 in our trade), both sets of options will expire worthless and you will keep your small net credit.
If March futures move lower than 1140 by expiration, the value of our long puts increases in value, creating a further credit to the trade. If March futures move higher, both puts expire worthless. Since we had a credit of 4c on the trade, this will still result in a net gain.
There is always risk, however. If March futures drop to 1140 and stay there to expiration, the position will have its maximum loss – but that is only at expiration.
Source: Pack Creek Capital and Optionsplaybook.com
What about implied volatility?
Once the trade is placed, an increase in implied volatility is almost always good. While it will increase the value of the option sold, it will also increase the value of the options purchased. Since we put this trade on for a net credit, a decrease in volatility if the option is above strike B is not terrible, as you can still get a little payoff. But in our case, implied volatility is welcomed.
For questions about this trade or other trades, feel free to reach us at [email protected]
Disclosure: The risk of loss in trading futures and/or options is substantial. Past performance is not indicative of future results. The information in this message derived from third-party sources is believed to be accurate and reliable; PCC does not guarantee the accuracy or completeness of the information. Opinions expressed in this material are subject to change without notice. This report should not be interpreted as a request to engage in any transaction of futures, options, and/or OTC derivatives. The information contained in this material is not to be relied upon in substitution for the exercise of your independent judgment. Seek independent financial, tax, legal and accounting advice from your own professional advisers, based upon your particular circumstances.