Previously in this column, we discussed net credit call backspreads. To recap, these spreads are created by shorting one or more contracts of lower strike call and going long on two or more contracts of higher strike calls. This week, we discuss why volatility is important for a backspread to be profitable.

Volatility bet

You must set up a call backspread when you are bullish on an underlying. Let’s say you expect the Nifty Index to test 18700, an upside potential of 415 points; also, suppose you short one contract of 18300 strike and go long on two contracts of 18500 strike. At the current prices, you can set up the spread for a 34-point net credit. The maximum risk is 166 points, the difference between the strikes less the net credit. 

The position gains most when the Nifty Index trades above 18666, the upper break-even (18500 plus the maximum risk). At 18666, the 18300 call will be 366 points in-the-money (ITM) and the 18500 call will be 166 points ITM. Thus, the loss on one 18300 call will be offset by the combined gains from two 18500 calls and the net credit. The next best outcome is when the Nifty Index trades below 18300; the gains equal the net credit. 

The above discussion suggests that the Nifty Index should move up sharply for the position to be profitable or should decline such that both strikes expire worthless. This alludes to the importance of volatility for a backspread.

Indeed, the position is sympathetic to vega, which captures the change in the option price for a percentage-point change in volatility. Suppose volatility increases by one percentage point for both strikes, the potential gains can be higher by 11 points, an increase of about 25 per cent. 

It is possible that the position generates larger gains when volatility increases because the demand for 18500 call will be greater than the demand for 18300 call if the Nifty Index moves towards past 18666. This is because the 18300 strike will be deep ITM, carrying lower liquidity and lower time value. Note that lower time value leads to lower implied volatility. 

Besides, time decay also hurts the position. For instance, if the Nifty Index were to move to, say, 18670 with three days to expiry instead of six days, the potential gain is likely to gain just 6 points, a decline of 86 per cent in potential gains. Logically, the position benefits from more time because it typically takes a while for an underlying to move up significantly. 

Take note
Lower time value leads to lower implied volatility; time decay hurts the position
Optional reading

Net-credit backspreads are more meaningful when you trade American options because you can exercise the options if you are unable to close the position. For European options, the long position is likely to become less liquid and the short position most likely inactive when the strikes become ITM. For this reason, you may be forced to close your position before it reaches its maximum potential gains.

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