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