Call Backspread

[Igor 10]

Traders who use a call backspread are betting that the market price of the underlying asset will go up substantially. The strategy involves buying two or more call options, and selling another, using the same underlying asset. Traders can decide which ratio works best for them, although the normal buy/sell ratio for this type of strategy is 2:1. Investors use a call backspread strategy to enter the market at low to no cost. Sometimes they even gain a credit, which they can use to offset any potential losses. At the same time, their returns are limitless, since the buy orders will always outweigh the sell orders. Thus, the maximum profit an investor can gain is infinite.

 

How to Enter a Call Backspread

A trader must perform two operations at the same time to enter a call backspread.

Example: XYZ is trading at $43 (market price)

 

 

Buying Two Calls

First, a trader will need to buy two calls that are Out-Of-The-Money (OTM).

1) Call Option Available: XYZJan45 ($2)

- One Option = 100 shares of XYZ stock

- Strike Price $45/per share, expiring on 1/15

- Premium Cost of $2.

2) Trader buys two call options and pays $400 (200 x $2 (premium cost)).

 

Selling a Call

Next, the trader will sell a call that's In-The-Money (ITM).

1) Trader writes (sells) call option: XYZJan40 ($4)

- One Option = 100 shares of XYZ stock

- Strike Price $40/per share, expiring on 1/15

- Premium Cost of $4.

2) Trader sells one call option and receives $400 from the buyer.

 

Result: The trader is in the options market, paying nothing to get in (Amount paid $400-$400 Amount Received).

 

Advantage and Disadvantage of Call Backspread

 

Pluses: The upside to this type of strategy is that there are no limits on the profit the investor can receive. If the market price of the underlying asset takes off, the investment will grow at the ratio implemented when entering the strategy, normally 2:1. Another advantage is that the cost of entering the market is either low to none, which depends on the difference between the two strike prices that the trader chooses when implementing the strategy. As a result, risk is limited.

 

Minuses: The downside in using a call backspread is losing money when the price of the underlying asset falls. Losses start when the market price of the underlining asset is between the strike price of the sale order and the strike price of the buy order, plus the points necessary to cover the short.

 

Examples Using the Buy and Sell Orders Above:

 

XYZ Market price declines to $39. (OTM)

Sell Order Result: The option expires OTM and worthless.

Buy Order Result: The option expires OTM and worthless.

Total result: The trader has no loss because he or she paid nothing to enter the market. If there was a credit in the account, the trader would keep it. If the trader paid more than he or she received to enter the strategy, the trader would lose that amount.

 

XYZ Market price increases to $50. (ATM)

Buy Order Result 1: The option expires ITM. The trader exercises his or her right to buy 200 shares at $45, and pays $9000 to whoever wrote the option.

Sell Order Result: The option expires ITM. The trader uses 100 shares from the buy order to cover the call, and receives $4000 from whoever bought the option.

Buy Order Result 2: The trader sells the remaining 100 shares at $50, market value and receives $5000.

Total result: Trader receives $4000(from sale) - pays $9000 (from buy 1) + receives $5,000 (from buy 2) = $0 gain. Thus, the investment broke even when XYZ hit $50.

 

XYZ Market price increases to $60. (ITM)

Buy Order Result 1: The option expires ITM. The trader exercises his or her right to buy 200 shares at $45, and pays $9000 to whoever wrote the option.

Sell Order Result: The option expires ITM. The trader uses 100 shares from the buy order to cover the call, and receives $4000 from whoever bought the option.

Buy Order Result 2: The trader sells the remaining 100 shares at $60, market value and receives $6000.

Total result: Trader receives $4000(from sale) - pays $9000 (from buy 1) + receives $6,000 (from buy 2) = $1000 gain.

 

Choosing the Correct Strike Price

In looking at the example above, one can see that the strike price plays a significant role in a call backspread strategy. If the trader had paid to enter the market, losses would occur when the market price of the underlying asset expires ITM for the sale order or below ATM for the buy order ($40-$50 respectively). Traders should choose strike prices that either gives him or her a credit or costs nothing when entering the market. Doing this will lower any potential loss if things go bad.