Backspreads (Reverse Ratio Spreads)
Backspreads, also known as reverse ratio spreads, are an option strategy utilized when you believe there will be much volatility in the stock but are not 100% sure whether it will go up or down.
If the stock moves a lot in the predicted direction, you will earn a tidy profit.
If the stock moves a lot, but in the opposite direction, you will earn a small profit.
However, if the stock doesn't move much and is stuck in a trading range, you will experience a loss.
The backspread position used when you are bullish on the stock is known as a Call Backspread, since call options are used to create this position.
The call backspread is created by buying a certain number of Out-of-The-Money (OTM) call options (i.
e.
call options whose strike price is higher than the current stock price), and selling a lesser number of In-The-Money (ITM) call options (i.
e.
call options whose strike price is lower than the current stock price).
You can create a call backspread by buying and selling any number of call options, but for the purposes of this article, we will talk about buying 2 OTM call options and selling 1 ITM call option.
Because you are selling a call option that is ITM and buying 2 call options that are OTM, this position should be a credit position, that is you will earn a premium by opening a call backspread.
However, because you are selling an option, you are not able to allow this position to expire.
You will need to buy back the option before expiration date, which brings us to the risks involved with this position.
If the stock price goes below the strike price of the call option that was sold (the ITM price), you can allow the position to expire since the calls at both strike prices are now worthless.
Your profit in this case would be the initial premium made when the position was opened.
If the stock moves above that ITM strike price but is still below the strike of the 2 calls that you bought (the OTM price), you will be in trouble.
The 2 calls with the OTM strike price would still be worthless, but the call you sold at the ITM strike price would be worth something and will need to be bought back before expiration.
Once the stock moves above the OTM strike price, your profits are limitless.
The ITM call will still increase in value (and must still be bought back), but that cost is negated by the fact that you now have the 2 calls (bought at the OTM strike price) gaining value just as quickly and can be sold for profit.
A Put Backspread functions in the same way but in the opposite direction, and is a bearish position.
You would use this position on a stock that you expect to move a lot, with a high likelihood that it will go down in price.
The reason it is known as a put backspread is because it is created by buying and selling put options.
The put backspread is opened by buying any number of out-of-the-money (OTM) put options (i.
e.
put options whose strike price is below the current stock price, and selling a smaller number of in-the-money (ITM) put options (i.
e.
put options whose strike price is above the current stock price).
Doing this should give you a net credit premium.
Similar to the call backspread, a put backspread can be created by buying and selling any number of put options, but for this article we will talk about the simplest case, which is selling 1 ITM put option and buying 2 OTM put options.
If the stock moves above the strike price of the ITM put option you sold, you can allow the position to expire and keep your original credit premium, since all 3 put options will be worthless.
If the stock price ends up between that ITM strike price and the strike price of the 2 OTM put options you bought, then you will incur a loss, since you will need to buy back the ITM put option which is now worth something, but the 2 OTM put options are still worthless.
Once the stock price drops below the strike price of the OTM put options, you will start to see unlimited profit since the cost of buying back the ITM put option is more than offset by the profits from selling the 2 OTM put options.
Do bear in mind that you cannot allow a backspread position to expire, since you have sold options that need to be bought back to prevent them being exercised.
As such, you will need to make sure you have enough funds to buy back those options in case the stock price doesn't move.
For a more detail and illustrations on backspreads, please visit: http://www.
option-trading-guide.
com/backspreads.
html
If the stock moves a lot in the predicted direction, you will earn a tidy profit.
If the stock moves a lot, but in the opposite direction, you will earn a small profit.
However, if the stock doesn't move much and is stuck in a trading range, you will experience a loss.
The backspread position used when you are bullish on the stock is known as a Call Backspread, since call options are used to create this position.
The call backspread is created by buying a certain number of Out-of-The-Money (OTM) call options (i.
e.
call options whose strike price is higher than the current stock price), and selling a lesser number of In-The-Money (ITM) call options (i.
e.
call options whose strike price is lower than the current stock price).
You can create a call backspread by buying and selling any number of call options, but for the purposes of this article, we will talk about buying 2 OTM call options and selling 1 ITM call option.
Because you are selling a call option that is ITM and buying 2 call options that are OTM, this position should be a credit position, that is you will earn a premium by opening a call backspread.
However, because you are selling an option, you are not able to allow this position to expire.
You will need to buy back the option before expiration date, which brings us to the risks involved with this position.
If the stock price goes below the strike price of the call option that was sold (the ITM price), you can allow the position to expire since the calls at both strike prices are now worthless.
Your profit in this case would be the initial premium made when the position was opened.
If the stock moves above that ITM strike price but is still below the strike of the 2 calls that you bought (the OTM price), you will be in trouble.
The 2 calls with the OTM strike price would still be worthless, but the call you sold at the ITM strike price would be worth something and will need to be bought back before expiration.
Once the stock moves above the OTM strike price, your profits are limitless.
The ITM call will still increase in value (and must still be bought back), but that cost is negated by the fact that you now have the 2 calls (bought at the OTM strike price) gaining value just as quickly and can be sold for profit.
A Put Backspread functions in the same way but in the opposite direction, and is a bearish position.
You would use this position on a stock that you expect to move a lot, with a high likelihood that it will go down in price.
The reason it is known as a put backspread is because it is created by buying and selling put options.
The put backspread is opened by buying any number of out-of-the-money (OTM) put options (i.
e.
put options whose strike price is below the current stock price, and selling a smaller number of in-the-money (ITM) put options (i.
e.
put options whose strike price is above the current stock price).
Doing this should give you a net credit premium.
Similar to the call backspread, a put backspread can be created by buying and selling any number of put options, but for this article we will talk about the simplest case, which is selling 1 ITM put option and buying 2 OTM put options.
If the stock moves above the strike price of the ITM put option you sold, you can allow the position to expire and keep your original credit premium, since all 3 put options will be worthless.
If the stock price ends up between that ITM strike price and the strike price of the 2 OTM put options you bought, then you will incur a loss, since you will need to buy back the ITM put option which is now worth something, but the 2 OTM put options are still worthless.
Once the stock price drops below the strike price of the OTM put options, you will start to see unlimited profit since the cost of buying back the ITM put option is more than offset by the profits from selling the 2 OTM put options.
Do bear in mind that you cannot allow a backspread position to expire, since you have sold options that need to be bought back to prevent them being exercised.
As such, you will need to make sure you have enough funds to buy back those options in case the stock price doesn't move.
For a more detail and illustrations on backspreads, please visit: http://www.
option-trading-guide.
com/backspreads.
html
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