By Steve Papale
It’s that time of the year. No I don’t mean spring – although it is and I for one am certainly ready for it. No I mean that 2 ½ week event that causes workers to take 2 hour lunches and come in the next morning sleepy due to that game that went into overtime and didn’t end until midnight. Yes its march madness and until April 6 and the final game, the tournament takes center stage for fans across the country. I have to get moving. I have a long lunch planned.
With large market swings like we’ve seen over the last couple weeks, some investors and traders may be concerned about a significant market selloff. We have not had a correction as defined by a 10% drop in the market since the summer of 2011. So some are saying we are long overdue in this 6 year old bull market. Maybe we are and maybe we aren’t but one relatively cheap way to protect yourself from a selloff is via a backspread.
A backspread is basically buying 2 options and selling one more expensive option. A bearish strategy might be to buy 2 April SPX 1900 puts for around $2.25 and sell 1 SPX April 1925 put for $3.10 for a net debit of $1.40. Since we are buying 2 options it is slightly long vega and short delta. Should the market selloff vols will likely rise and our spread will benefit by being long vega. In addition our deltas get gradually more short as we move down toward the strikes. The risk is since we are essentially short 1 1900/1925 put spread with 1 extra long put, is if we settle at the 1900 strike. In that case our 1 short put spread would cost us and we would have no benefit from the 1 extra 1900 put we are long. The key to avoiding this is to manage this trade by closing or rolling the spread if we get close to the long1900 strike near expiration. If the market moves down there with more than a week or so left to expiration, the spread will be fine due to the remaining extrinsic value in the options. These various scenarios can be easily modeled in the software.