lower strike, the IV is naturally higher for the 70 calls. This is vertical skew
and is described in Chapter 3. The phenomenon of lower strikes in the same
option class and with the same expiration month having higher IV is very
common, although it is not always the case.
Backspreads usually involve trading vertical skew. In this spread, traders
are buying a 30 volatility and selling a 32 volatility. In trading the skew, the
traders are capturing two volatility points of what some traders would call
edge by buying the lower volatility and selling the higher.
Based on the greeks in Exhibit 16.2 , the goal of this trade appears fairly
straightforward: to profit from gamma scalping and rising IV. But, sadly,
what appears to be straightforward is not. Exhibit 16.3 shows the greeks of
this trade at various underlying stock prices.
EXHIBIT 16.3 70–75 backspread greeks at various stock prices.
Notice how the greeks change with the stock price. As the stock price
moves lower through the short strike, the 70 strike calls become the more
relevant options, outweighing the influence of the 75s. Gamma and vega
become negative, and theta becomes positive. If the stock price falls low
enough, this backspread becomes a very different position than it was with
the stock price at $71. Instead of profiting from higher implied and realized
volatility, the spread needs a lower level of both to profit.
This has important implications. First, gamma traders must approach the
backspread a little differently than they would most spreads. The
backspread traders must keep in mind the dynamic greeks of the position.
With a trade like a long straddle, in which there are no short options, traders
scalping gamma simply buy to cover short deltas as the stock falls and sell
to cover long deltas as the stock rises. The only risks are that the stock may
not move enough to cover theta or that the traders may cover deltas too
soon to maximize profits.