Net credit OTM backspread

A

alassio

Currently I observe a rather steep volatility curve in DAX index options, which allows me to put on the following position for a net credit:
Short 1 July06 5850 DAX option for 22.1
Long 2 July06 5950 DAX options for 6.6
=> net credit 8.9
(DAX is currently at 5700 with 25% vol and 3 weeks to go)

My analysis suggests that this position should win if the DAX stays, falls or advances quickly. It will loose if it slowly creeps up into the loss region 5850-5950.

However I am not quite sure, how the position will behave with regard to the steep volatility curve. I consider it a well protected short premium position. Do you agree?

Regards, alassio
 
I assume those are calls. If that is the case then what you have is a call backspread, which is a long volatility play. Sort of like long straddle, but with capped profit to the downside.

The max profit to the downside is below 5850 and is equal to your net credit. The max profit to the upside is unlimited. The max loss at expiry is at the long strike (5950). In other words, you want DAX to either stay flat, go down or make a significant move to the upside.

If you hold this to expiry then the volatility smile is of no concern. Prior to expiry your risk is that the volatility will drop.

With 3 weeks to expiry and 25%, 1 standard deviation move is about +/- 6%.
 
Quote from MTE:

...If you hold this to expiry then the volatility smile is of no concern. Prior to expiry your risk is that the volatility will drop.

With 3 weeks to expiry and 25%, 1 standard deviation move is about +/- 6%.
More...

Well, I will hold it to expiration if it goes down or stays flat. The volatility considerations come into play if it continues to move up:
Because of the steep volatility curve, volatility should not drop for these calls if the DAX is moving up. If it is moving down, the short call is losing value even more quickly. The only concern is whether the long calls are enough protection if we have a move above 5850 in the next 2 weeks.
The thinking behind the position is actually a call credit spread with additional protection which we can afford because of the steep volatility curve.
 
Quote from alassio:

Well, I will hold it to expiration if it goes down or stays flat. The volatility considerations come into play if it continues to move up:
Because of the steep volatility curve, volatility should not drop for these calls if the DAX is moving up. If it is moving down, the short call is losing value even more quickly. The only concern is whether the long calls are enough protection if we have a move above 5850 in the next 2 weeks.
The thinking behind the position is actually a call credit spread with additional protection which we can afford because of the steep volatility curve.
More...

Why don't you just plug the trade into an option pricing model/analysis program and see what happens under various scenarios.
 
Quote from MTE:

Why don't you just plug the trade into an option pricing model/analysis program and see what happens under various scenarios.
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That's what I did. However, my model doesn't simulate the volatility curve. So I wonder whether there may be surprises.
 
Quote from alassio:

That's what I did. However, my model doesn't simulate the volatility curve. So I wonder whether there may be surprises.
More...

You can just model them separately and then combine to see the overall result.
 
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