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training_data/relevant/text/4b2053cb5f80a73b4d0d60165f969440857e8b4b81b32b555fc6a9010499516a.txt

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+834 Part VI: Measuring and Trading Volatility 
+described in the chapter on reverse spreads. The reader might want to review that 
+chapter, not only for the description of the strategy, but also for the description of the 
+margin problems inherent in reverse spreads on stocks and indices. 
+One of the problems that most traders have with the reverse calendar spread is 
+that it doesn't produce very large profits. The spread can theoretically shrink to zero 
+after it is sold, but in reality it will not do so, for the longer-term option will retain 
+some amount of time value premium even if it is very deeply in- or out-of-the-money. 
+Hence the spread ·will never really shrink to zero. 
+Yet, there is another approach that can often provide larger profit potential and 
+still retain the potential to make money if implied volatility decreases. In some sense 
+it is a modification of the reverse calendar spread strategy that can create a poten­
+tially even more desirable position. The strategy, known as a volatility backspread, 
+involves selling a long-term at-the-money option (just as in the reverse calendar 
+spread) and then buying a greater number of near-er term out-of-the-money options. 
+The position is generally constructed to be delta-neutral and it has a negative vega, 
+meaning that it will profit if implied volatility decreases. 
+Example: XYZ is trading at 115 in early June. Its options are very expensive. A trad­
+er would like to construct a volatility backspread using the following two options: 
+Call Option 
+July 130 call: 
+October 120 call: 
+Price 
+2.50 
+13 
+Delta 
+0.26 
+0.53 
+Vega 
+0.10 
+0.27 
+A delta-neutral position would be to buy 2 of the July 130 calls and sell one of 
+the October 120 calls. This would bring in a credit of 8 points. Also, it would have a 
+small negative position vega, since tvvo times the vega of the July calls minus one 
+times the vega of the October call is -0.07. That is, for each one percentage point 
+drop in implied volatility of XYZ options in general, this position would make $7 -
+not a large amount, but it is a small position. 
+The profitability of the position is shown in Figure 39-6. This strategy has lim­
+ited risk because it does not involve naked options. In fact, if XYZ were to rally by a 
+good distance, one could make large profits because of the extra long call. 
+Meanwhile, on the downside, if XYZ falls heavily, all the options would lose most of 
+their value and one would have a profit approaching the amount of the initial credit 
+received. Furthermore, a decrease in implied volatility produces a small profit as 
+well, although time decay may not be in the trader's favor, depending on exactly 
+which short-term options were bought. The biggest risk is that XYZ is exactly at 130 
+at July expiration, so any strategist employing this strategy should plan to close it out