The Put Backspread Hedge

The Canadian market has continued to complacently forge ahead. Overall we have seen little progress higher throughout March as the international geopolitical circumstances in Cyprus and Korea have started to slowly taper investor enthusiasm.

In past blogs, the current state of the implied volatility priced into index options has been referenced using the VIXC which today is presently consolidating around 13.00.

By observing the historical data, one can quickly recognize that it sits near multi year lows. We have been quick to demonstrate that this represents a compelling opportunity to insure the downside risk of equity investments through the purchase relatively low cost puts. In spite of the relatively low costs, there are a number of details that investors must consider:

1. If the stock continues to rise, the protective puts will materialize a loss that increases the investor’s cost base.
2. If the stock does drop and the put did provide the hedge, one does not necessarily benefit from an expansion of volatility unless the trader was nimble enough to time a quick flip of the put.

This is where I would like to debate the use of a put backspread as an alternative to put protection. I find this interesting because most sophisticated traders that trade the backspread use it as a directional bearish strategy to express their trading views. On the other hand, what if you executed that put backspread as a protective strategy on existing equities? Let’s explore.

The backspread is a reverse put ratio spread. This involves selling 1 at-the-money put and buying 2 out-of-the-money puts. What makes this strategy compelling is that it is built to profit not only from a rapid market decline, but equally from rapid expansion of volatility.

As an example, let’s look at CIBC shares that are trading at $80.01 (April 1, 2013). The investor owns 1000 shares. A traditional protective put like the July $80.00 would have cost $2.50 ($2,500) or just over 3%.

CIBC put backspread alternative.

• Sell 10 July $80.00 puts for $2.50 ($2,500.00 credit).
• Buy 20 July $76.00 puts for $1.20 ($2,400.00 debit).

What are the benefits?

If we had a global event (think Europe or Korea), the market could rapidly turn bearish as traders and investors abandon risk assets. This quite often would lead to spike in volatility. As an example, it would take a 50% increase in volatility for the VIXC to just return back to its November 2012 highs around the 19 level. The fact that the investor is long twice the number of puts as they are short, the spread will profit from a rapid drop in the stock as volatility premium tends to expand. Under $76.00 there is no further downside risk as 10 of the 20 July $76.00 puts could be used to exit the long stock position.

More importantly, if CIBC was to stay the same or go up in price, there was no cost to the hedge. Recognize that the net position was a credit so if the shares are trading above $80.00 at expiration all options will expire at no cost to the investor.

What is the downside risk?

The max risk would be only if the stock closes exactly at $76.00 on the July expiration. This one scenario would have the investor being down $4.00 on the stock from the $80.00 current price, plus being out a further $4.00 on the July $80.00 puts.

Why is this an alternative for investors to consider?

Many investors are intimidated by the ongoing costs of protecting stocks that are clearly bullish. By utilizing the put Back Spread as a hedge:

• The downside risk of CIBC below $76.00 has been completely removed.
• If the stock continued to perform, it cost the investor nothing to be hedged.
• The pain point is that if CIBC closed at $76.00 on the July expiration, the investor would find themselves sitting at a $4.00 loss on the options spread while being equally down the stock.

Certainly it is a strategy that investors can consider if it suits their outlook on the stock.