Introduction To Call Backspreads
A call backspread involves buying more out of the money calls than shorting in the money calls and what this creates is a limited loss and unlimited potential profit risk and reward profile. The call options which are bought and sold are derived from the same underlying security but have different strike prices. The prices between the upside and downside breakeven points will result in a loss for the trader that executes this trade. Hence, a trader would want the prices to trade below the downside breakeven point or above the upside breakeven point. With regards to the call backspreads option strategy, the investor’s sentiment must be an upside bias to the price of the underlying security. As you can see in the risk/reward graph, the gradient slopes upwards after a certain point and continues constantly thereafter. That means that the higher the eventual price of the underlying security, the greater the price increase of the underlying security, the more profits the investor will make.
Steps:
2. Net credit or Net Debit
3. Perform Economic, Technical & Fundamental Analysis
4. Outlook : Very Bullish
5. Look at the option chain
6. Breakeven Analysis : Calculating Upside and downside breakeven points for the call backspread
7. Understand your profit zones
8. Call backspread, a limited loss strategy
9. Learn To Calculate Loss
10. Uncapped profit
11. Calculate Potential Profit For Call Backspread
12. Calculate The Risk & Reward Ratio
13. Setting Up The Trade : Creating a call backspread
14. Exit strategies for call backspread
15. Record your call backspread trade in a trading diary
2. Net credit or Net Debit
Constructing a call backspread may result in a net credit or a net debit.
3. Perform Economic, Technical & Fundamental Analysis
Before a trader executes a call backspread, the trader should perform economic analysis, fundamental analysis and technical analysis to determine if he should enter into a call backspread trade. Preferably, the economy should have some upside to it. The fundamentals of the company should be sound and the company should be undervalued. There should be some form of catalyst that will cause the price of the underlying security to increase. The catalyst can come in the form of earnings growth, increased dividends or a rerating of the underlying security. Next, traders should determine when to place a call backspread by using technical analysis. Of course, these are just guidelines with regard to placing a call backspread trade. Very often, the stars are not aligned. Investors or traders should make use of whatever information that is available and then making a decision. It is after all a matter of probability. Performing this step increases the probability that the trader or investor will earn money. Why perform this step anyway? That is because the options that the investor buys will expire within a certain time frame. So it helps that the trader has favorable odds on his side to come out of a trade profitably.
Some chart patterns to look out for are:
Do note that this is not meant to be exhaustive. Other traders may use bollinger bands, Fibonacci, moving averages, elliot waves and more to determine whether the outlook is bullish. This list goes on.
Read : Basic Economic Analysis, Basic fundamental Analysis and Introduction to technical analysis
4. Outlook : Very Bullish
A trader that executes a call backspread should look for a market where a sharp rise in the underlying security is anticipated with increasing volatility. The trader has to be bullish. Placing a trade where markets are range bound will result in a loss. Also, the time value of the purchased options will erode over time. It is imperative that the trade works out within the life of the options.
5. Look at the option chain
Once a trader is very bullish on a particular security, he should look at the option chain to select the option strike prices for his call backspread.
Read : Learn to read and understand options chain
6. Breakeven Analysis : Calculating Upside and downside breakeven points for the call backspread
It is essential to calculate the upside and downside breakeven points. The formula varies depending on whether a net debt or a net credit is created. Whether a net debt or credit is created is dependent on the option premiums of the options used within the trade.T he formulas are shown here.
Upside breakeven point = Strike price of purchased call + ( Strike price of purchased call – Strike price of short call + net debit + brokerage fees paid )
Apply the above formula if a net debit is created.
Upside breakeven point = Strike price of purchased call + ( Strike price of purchased call – Strike price of short call – net credit + brokerage fees paid )
Apply the formula above if a net credit is created.
Downside breakeven point = Strike price of short call + net credit or – net debit
7. Understand your profit zones
Every time the price of the underlying security trades below the downside breakeven point or the upside breakeven point, the trade is profitable. This is in relation to the breakeven analysis done in the preceding step.
8. Call backspread, a limited loss strategy
In a call backspread, the potential loss is limited.
9. Learn To Calculate Loss
This limited loss can be calculated as:
Strike price of purchased call – Strike price of short call + net debit + brokerage fees paid
Or
Strike price of purchased call – Strike price of short call – net credit + brokerage fees paid
This limited loss is also known as the strategy’s maximum loss. This maximum loss will occur when the price of the underlying instrument is equal to the strike price of the purchased call.
10. Uncapped profit
The call backspread can attain an uncapped and unlimited profit to the upside. A profit is realisable when the price of the underlying security is greater than the upside breakeven point. To calculate the upside breakeven point, do refer to the formula below.
11. Calculate Potential Profit For Call Backspread
The profit of a call backspread can be calculated as:
Price of the underlying security – Strike price of purchased call – ( Strike price of purchased call – Strike price of short call + net debit + brokerage fees )
The above formula is to be used when the trade results in a net debit.
If the trade results in a net credit, the profit of the call backspread can be calculated as:
Price of the underlying security – Strike price of purchased call – ( Strike price of purchased call – Strike price of short call – net credit + brokerage fees )
To calculate your potential profit, a trader should estimate the target price of the underlying security. This can serve as a potential exit price, that is, the price at which the trade is exited.
12. Calculate The Risk & Reward Ratio
For every dollar of risk that a trader takes, what is the potential profit? Is the potential profit worth the risk? If the trade can earn only $0.50 for every dollar risked, the trade may not make sense. However, if the trader can earn $10 for every $1 risked, the call backspread would make sense on a risk reward basis.
Read more : Understanding Risk/Reward Ratio For Option Traders
13. Setting Up The Trade : Creating a call backspread
Typically, to construct a call backspread, for every 2 out of the money call contracts which are bought, 1 in the money call contract is shorted. The out of the money call options which are bought have a higher strike price than the in the money call which is shorted.
Narrower strike prices vs wider strike prices
When the strike price between the bought options and the shorted options are wider, considering that the shorted options are in the money, the premium collected from the shorted options would be quite substantial. With that being the case, an options trader may not need to short as many options for the collected premium from the shorts to be more than the paid premiums for the bought calls.
Hence the ratio of calls bought to the calls shorted may not always be 2 : 1. Variations to the ratio do exist and the whole idea is to be able to cover the premium forked out for the bought calls to such an extent that a credit is made to the trading account. This is the reason why call backspreads are sometimes known as credit spreads.
14. Exit strategies for call backspread
1. An options trader who executes a ratio backspread should consider the possibility of assignment for the shorted options. When the shorted options are in the money, have littles time value left, assignment can occur. In general, if there is a quarter point of time value left in the shorted options, there is a high probability of assignment. It would be wise to close the trade at this point.
2. Since options experience a rapid rate of time value decay towards expiration, exit the backspread if there is no more than 30 days to expiration.
3. If the call backspread is already profitable and the profits are reasonable to the trader, the trader can close an equal number of short options and long options and leave the remaining long option to capture additional profits.
4. If the price of the underlying security traders between the upside and downside breakeven point, the trade is incurring a paper loss. If there is no more than 30 days to expiration, the trader may want to consider exiting the trade entirely.
5. If the price of the underlying security falls below the downside breakeven, the trader may want to let the options expire worthless to keep the net credit if there is any.
15. Record your call backspread trade in a trading diary
Analyse your trade and find out what mistakes were made and what could have been done better. Record it once the trade has been offset or closed.
Put backspread
The put backspread is a bearish strategy that involves put options. Both the call backspread and the put backspread have a similar payoff profile.