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 right

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 three options.

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.

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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.