Backspread options strategy is best used if you are expecting a large
move up or down, but are more bullish than bearish.
option-info and options-graphs sites:
Outlook: Bullish or bearish, but not neutral. The stock must fall
or rise for the strategy to gain. Gain is limited to the downside.
buy two Calls ATM and sell Call ITM.
when: stock rises or falls past the breakeven points.
Gain: Unlimited to the upside, limited to the downside.
when: stock does not rise or fall enough.
Loss : limited to the difference in strike prices - the initial credit.
Calculation: Lower breakeven = Short Call strike + initial credit.
Upper breakeven = Long Call Strike + difference in strike prices - initial
compared to stock: limited risk, less capital needed, greater leverage,
can gain from a move in either direction.
compared to stock: Position will lose if stock does not move, or does
not move enough.
after entry, increasing implied volatility is positive if the stock
does not move, or rises.
after entry, the passage of time is negative if the stock does not
move, or rises.
Requirement: The difference in strike prices x the number of shares
short represented, less the initial credit.
See the Backspread with Puts
if you think there is a greater chance of a sharp drop in the stock price.
Backspread can be used if you expect a sharp stock price movement one
way or the other, but are mostly leaning bullish. For instance, you
may expect such a movement at earnings time on a stock that historically
has large movements in reaction to the earnings report.
- If you
are purely bullish, buying a single ATM call would have a lower breakeven,
a lower maximum loss, and more profit potential. This Backspread only
makes sense if you want to allow for the possibility of a sharp downward
movement as well as a sharp upward movement.
- The strategy
has limited profit potential to the downside, so you don't want to be
"too" bearish. Use the Backspread
with Puts if you are more bearish than bullish.
- A somewhat
similar strategy is the Straddle Purchase. Compared to a Straddle Purchase,
entered for a credit instead of a debit.
a lower maximum loss.
gain as much if the stock drops dramatically.
about the same profit potential to the upside.
similar strategy is a Butterfly Sale (aka reverse
Butterfly). Compared to a Butterfly Sale, this Backspread:
entered for less of a credit.
a greater maximum loss.
more movement to be profitable.
much more profit potential to the upside.
this strategy needs stock price movement to be profitable, if the stock
does not move as expected, it is best to exit the trade with less than
the maximum loss. Using the example graph, if the stock has not moved
within two weeks (and you were expecting the movement by then), you
can exit for a loss of about $100. If you just sit and wait, you may
have to take a loss of over three times that much - $357.
- If the
stock drops, and you were really expecting a rise, it may be best to
take whatever small gain or loss you have. Waiting could result in a
reaction back to the worst possible price range.
- If the
stock rises over the upper breakeven point
at any time, you will have a gain, but time will be working against
you, and there is always the possibility of a reversal. You will need
to decide if the stock is having a strong enough upward move to justify
holding the position.
- It is
possible, but not likely, that you can get two free or nearly free long
calls if the stock drops dramatically. Then you can close out just the
short call, making a gain that may pay for or come close to paying for
the long calls. Then you would need some sort of a rebound so the long
calls could recover some of their value. If you try to plan in advance
for this scenario, it probably won't occur often enough to be worthwhile.
But if you are in a Backspread trade anyway, it may pay to remember
it. See the Free Rides:
Guaranteed Winning Trading Strategies? page