To back-book an option or options is effectively
trade them, at a price of zero, out of the main portfolio
(hereafter the 'front-book') and into the 'back-book'. The
delta hedge held against the options whilst in the front-book
is taken off during the transfer to the back-book. In other
words, back-booking involves transferring delta-hedged options
from the front-book to the back-book and trading out of the
accompanying delta hedge. The result is that the hedged options
disappear from the front-book and appear as un-hedged options
in the back-book.
Why would a trader wish to segregate and de-hedge
his position in this way? There are several possible
justifications. For example, consider call options that
currently have zero delta and little or no value. If the spot
product rallies in price, the calls may start to accrue a delta
which the trader might be inclined to hedge (this being a
straightforward gamma hedge).
But imagine if the spot product between now and the
options' expiration simply rallies to the call strike price
without retracement. Throughout this rally, the delta-neutral
trader will be selling deltas, all of which must be bought back
at the options' expiration, at a loss.
The risk of this steady, one-way move can be
eliminated by back-booking. By back-booking the calls when they
have a very low or zero delta, the trader will avoid gamma
hedging during the rally. Note, that this
could be a mistake if the spot rallies, the trader were to sell
deltas and then the spot were to fall again. This represents
the opportunity cost of back-booking options.
What back-booking does give the trader is a way to
eliminate a risk that is associated with a particular type of
movement in the underlying product.
Profitable in its own
Furthermore, the back-book has the potential to
become highly profitable in its own right. Remember, the
back-book contains un-hedged long options (back-booking
typically only involves long options, or short options that
have long options 'in front of them', such as long call spread
or long regular butterfly positions). Any value associated with
them is written-off at the time of the back-booking.
Now, if the spot product does indeed move towards
the back-booked options before expiration, the back-book may
become valuable. Indeed if the spot product moves through the strike price of the back-booked
options, the back-book can become extremely valuable; at this
point, the volatility trader is seeing some of the explosive
benefits more normally associated with trading options directionally.
In this happy situation, a trade that was entered
into ostensibly to minimise risk can become significantly
profitable. How then does the trader capitalise on this? He has
Firstly, he can re-introduce the back-book into the
front book; front-booking if you will. This process is the
perfect reverse of back-booking; the un-hedged options are
transferred at a price of zero into the front-book and are
delta-hedged with the appropriate current delta. From this
point, they are treated like any other volatility trade and the
profits are accrued by gamma hedging. Note that this option
does not guarantee a profit on the back-book (if for example
the spot product becomes sticky and no gamma scalps are
forthcoming, the options will still experience time decay).
Secondly, he can sell the back-book directly in the
market. Unlikely to be a popular choice with liquidity
providers (since they will be crossing the bid-ask spread when
selling) but sometimes the simplest solution particular if
expiration is approaching and liquidity is doubtful or if the
back-book is a slightly complex strategy such an irregular
condor or ratio structure that the trader would rather simply
be shot of. This option locks in the profit from the
back-booking at a stroke, less the cost of crossing bid-ask to
hit the bid.
Thirdly, for back-books that are fully in-the-money
(prior to expiration) the trader can elect to hedge the options
entirely. For example, if the 101 calls are back-booked and
following a corporate action the stock price gaps from $95 to
$102, then the trader could hedge the 101 calls with a 100%
delta. The effect, via put-call parity, is to convert the $101
back-booked calls into the $101 back-booked puts (un-hedged)
and to lock in a dollar of profit. If the stock rises further,
the trader has nothing to do, since he has fully hedged, other
than exercise his calls at expiration.
Instead, he is hoping for a drop in the share
price, since below $101 at expiration he has all the shares to
buy back (as they are not required as a hedge against the $101
calls which would be out-of-the-money below $101). Of course
the trader could have just fully-hedged some
of the calls following the gap higher, allowing for further
rises. Aside from some possible minor issues relating to cost
of carry for deep in-the-money options, the situation is one
almost entirely without downside.
Back-booking is a useful technique that over time can reduce
risk and occasionally generate spectacular profits. Any
volatility trader with a portfolio of considerable scope should
be aware of its potential and applicability.
About the Author:
Simon Gleadall is the chief executive of Volcube, the derivatives
training technology company. He also writes on matters of
derivatives trading and risk management and is the author of
The Metaphysics of Markets, a primer in the
philosophy of finance.