In both cases, a (usually near the money) option is sold and used to partially fund the purchase of two (or more) out-of-the-money options. Let’s see an example:
Let’s say Apple was $710 at the beginning of September, and we anticipated a quick rise in value. We might implement a call backspread:
- Sell 1 AAPL Sep 710 Calls
- Buy 2 AAPL Sep 720 Calls
It might cost us $50. Here’s the profit and loss diagram:
As illustrated, if we are correct and AAPL rises, we will benefit from any increase over $720; for every $1 above $720, we make a $100 profit—all for an investment of just $50. This demonstrates the potential profitability of this strategy.
Conversely, if we are completely wrong and AAPL falls significantly, our loss is limited to $50.
The primary risk arises if AAPL hovers around $710, where there’s a potential loss of $1,000.
Call Ratio Backspread vs. Put Ratio Backspread
A put ratio backspread is a bearish options trading strategy that combines short puts and long puts to create a position whose profit and loss potential depends on the ratio of these puts. This strategy seeks to profit from the volatility of the underlying stock, combining short and long puts in a specific ratio as determined by the options investor.
Similar to the call ratio spread, the put ratio spread involves buying several put options and selling one put option to help finance the purchase of the two puts.
If the stock declines significantly, the strategy profits from the two puts, offsetting any loss from the one put that was sold.
Reduce Risk Of No Movement
In the previous lesson, we discussed how backspreads can be utilized to exploit expected sharp moves in stocks, using the AAPL call backspread as an example. We identified that the key risk at expiration is non-movement in AAPL. So, how can we mitigate this?
The essential strategy for managing non-movement risk is to avoid holding the position until expiration.
Revisit the profit and loss diagram. The dotted line represents the profit and loss two weeks before expiration. Notice that any loss—how much the dotted line is below $0—is minimal, and less than the worst-case scenario at expiration of $710. Additionally, the upside has already been realized by this point; the gap between the two lines narrows as the stock rises above $710.
This is crucial for successfully trading backspreads. It is possible to capture most of the upside with minimal risk if we exit our position well before expiration.
Before we delve into how to exploit this, let’s examine the (somewhat complex) Greeks of the backspread.
Backspread Greeks
Let’s explore the options greeks of the backspread and how they might influence our strategy, using our AAPL call backspread example for illustration.
Delta
For most of the time before expiration, the delta of a (call) backspread is positive, except when the underlying falls significantly, causing delta to flatten or turn slightly negative.
Gamma
Gamma is positive where it matters most, as the underlying rises.
Theta
Theta represents a key risk with backspreads. As time progresses without stock movement, the backspread incurs losses; it has a positive theta that increases over time. Thus, we should avoid holding the position close to expiration.
Vega
Vega is positive. As volatility rises, the position appreciates in value.
This makes the call backspread our preferred choice. If we misjudge the trade and the stock falls (when we want it to rise), an increase in volatility offers some protection, as the position will rise with positive vega. Volatility acts as a natural hedge.
Rho
Given the short duration we plan to maintain the position, rho is not a significant concern.
The key takeaway is that we want our stock to move quickly after initiating the position. If it fails to move or moves in the wrong direction, we will exit the trade well before time decay from theta impacts us.
Backspread Adjustments
General View Of Adjustments
At SteadyOptions, we generally advise against making adjustments.
Adjusting a losing position in hopes of recovery is akin to doubling down on a bad bet; it can lead to a loss that is too large to recover from. Adjustments often involve increasing a position and/or risk, which can be disastrous.
Backspreads Are A Possible Exception
However, backspreads can be an exception. Since the loss on a poorly performing position remains small well before expiration, it is feasible to close it for a minor loss and then establish a new backspread at a different (lower for a call backspread) strike price.
The key, as always with adjustments, is to only proceed if we would be willing to initiate the resulting position fresh.
For instance, if we anticipate a strong positive announcement regarding a stock that hasn’t yet occurred, we may want to adjust our position to continue seeking the significant move.
When Would We Consider Adjusting?
Referring back to our call backspread example from earlier, we initiated the following trade for $50 about 30 days from expiry, with AAPL at $710 (expecting it to rise before the month ends):
- Sell 1 AAPL Sep 710 Calls
- Buy 2 AAPL Sep 720 Calls
Suppose a few days later, AAPL drifts down to $700. As shown in the P&L diagram, this is not catastrophic, even though the stock has moved in the wrong direction:
The ‘loss’ on the trade may only be $5-$10 or even less.
However, the more significant issue is that the stock has moved away from the profitability zone (currently around $705 and moving higher). Additionally, the stock would soon need to surpass the trade’s highest point (approximately $710) to reach profitability, significantly reducing the likelihood of success.
So, what should we do?
We could simply exit the trade for a minimal loss, which is usually our recommendation. However, adjusting back to something resembling the original trade is relatively inexpensive early in the trade.
Possible Adjustment
How would we adjust? We could remove the existing backspread and establish a new one centered on $690:
Remove original backspread:
- Buy 1 AAPL Sep 710 Calls
- Sell 2 AAPL Sep 720 Calls
- Proceeds: $45
Set up new backspread:
- Sell 1 AAPL Sep 690 Calls
- Buy 2 AAPL Sep 700 Calls
- Cost: $50
The net cost is minimal ($5)—though it may be higher due to commissions and slippage.
This last point is crucial: you’ll need to evaluate whether the total cost is justified for the adjustment. The thought process is, as always, would I be comfortable initiating this position fresh at this cost (including adjustment costs)?
Call Backspreads: Trade Plan
Let’s summarize everything we’ve learned and outline a comprehensive game plan for trading Call Backspreads…
Step 1: Choose Your Underlying
This is crucial.
You should only consider a call backspread if you believe a stock is poised for a rapid increase in value.
Step 2: Implement a Call Backspread ‘Centered’ on the Current Price
For instance, if you believe EBAY will rise from its current $52, you could sell a 50 EBAY call and buy 2 52 EBAY calls (with the same expiry).
A timeframe of 30-40 days is ideal.
Step 3: Close if Position Loses or Gains 20%
Our goal is to enter and exit these trades swiftly, aiming to achieve more winners than losers.
Step 3 (Alternative)
Alternatively, you might choose to adjust if the position loses 20% with 20 days or more remaining until expiry.
If so (i.e., you still believe the stock will rise), close the position and return to Step 2.
(Be cautious: this method only aims to recover your loss and is advisable only if you are confident the stock will rise quickly soon.)
The Bottom Line
Backspreads can be an effective strategy for experienced options traders seeking to profit from significant price movements in the underlying asset while managing potential losses. By selling a certain number of call/put options and simultaneously buying a greater number of call/put options, traders can create a spread with unlimited profit potential.
However, it’s important to note that backspreads are a complex strategy that requires a good understanding of options trading and market dynamics. Traders and investors should carefully weigh the risks and rewards, including the maximum profit and loss potential, before incorporating this strategy into their portfolio. With proper knowledge and risk management techniques, backspreads can be a valuable addition to a trader’s options toolkit. Another unique use of the backspread is Earnings Ratio Spread.
About the Author: Chris Young has a mathematics degree and 18 years of finance experience. Chris is British by background but has worked in the US and lately in Australia. His interest in options was first aroused by the ‘Trading Options’ section of the Financial Times (of London). He decided to bring this knowledge to a wider audience and founded Epsilon Options in 2012.
Subscribe to SteadyOptions now and experience the full power of options trading at your fingertips. Click the button below to get started!
Related articles
