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