With the backspread, the changing gamma adds one more element of risk.
In this example, buying stock to flatten out delta as the stock falls can
sometimes be a premature move. Traders who buy stock may end up with
more long deltas than they bargained for if the stock falls into negative-
gamma territory.
Exhibit 16.3 shows that with the stock at $68, the delta for this trade is
−2.50. If the traders buy 250 shares at $68, they will be delta neutral. If the
stock subsequently falls to $62 a share, instead of being short 1.46 deltas, as
the figure indicates, they will be long 1.04 because of the 250 shares they
bought. These long deltas start to hurt as the stock continues lower.
Backspreaders must therefore anticipate stock movements to avoid
overhedging. The traders in this example may decide to lean short if the
stock shows signs of weakness.
Leaning short means that if the delta is −2.50 at $68 a share, the traders
may decide to underhedge by buying just 100 or 200 shares. If the stock
continues to fall and negative gamma kicks in, this gives the traders some
cushion to the downside. The short delta of the position moves closer to
being flat as the stock falls. Because there is a long strike and a short strike
in this delta-neutral position, trading ratio spreads is like trading a long and
a short volatility position at the same time. Trading backspreads is not an
exact science. The stock has just as good a chance of rising as it does of
falling, and if it does rise and the traders have underhedged at $68, they will
not participate in all the gains they would have if they had fully hedged by
buying 250 shares of stock. If trading were easy, everyone would do it!
Backspreaders must also be conscious of the volatility of each leg of the
spread. There is an inherent advantage in this example to buying the lower
volatility of the 75 calls and selling the higher volatility of the 70 calls. But
there is also implied risk. Equity prices and IV tend to have an inverse
relationship. When stock prices fall—especially if the drop happens quickly
—IV will often rise. When stock prices rise, IV often falls.
In this backspread example, as the stock price falls to or through the short
strike, vega becomes negative in the face of a potentially rising IV. As the
stock price rises into positive vega turf, there is the risk of IV’s declining. A
dynamic volatility forecast should be part of a backspread-trading plan. One
of the volatility questions traders face in this example is whether the two-