In both cases, an option (usually near-the-money) is sold and used as part of the funds to purchase two (or more) out-of-the-money options. Let’s take an example:
Let’s say Apple’s price was $710 in early September and you thought the price would rise soon. A call back spread may be established.
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Sold 1 AAPL September 710 call
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Buy 2 AAPL September 720 calls
It might cost $50. The profit and loss chart is as follows.
As you can see, if we are correct, AAPL will rise and enjoy an increase above $720. Earn $100 in profit for every $1 you spend over $720. All for a $50 investment. So you can see how lucrative this can be.
Even if we’re completely wrong and AAPL drops significantly, you’ll only lose $50.
The risk is that AAPL remains near $710. There is a possibility that you will lose 1000 yen.
Call ratio backspread and put ratio backspread
Put ratio backspread is bearish option A trading strategy that combines short and long puts to create positions whose potential for profit and loss depends on the ratio of these puts. The put ratio backspread is so called because it attempts to profit from the volatility of the underlying stock by combining short and long puts at the option investor’s discretion.
Put ratio spreads are similar to call ratio spreads, but instead of buying two or more call options and selling one call option to finance a strategy, you buy multiple put options and sell one call option. Sell a put option to finance the purchase of two puts. .
If the stock price falls significantly, this strategy makes a profit from the two puts, offsetting the loss from the one put sold.
Reduce the risk of immobility
In the previous lesson, we saw that backspreads can be used to take advantage of expected stock price spikes. As an example, we looked at the backspread on AAPL calls. We also find that the main risk at expiration is that his AAPL does not move. How should I deal with this?
The key to managing non-movement risk is not to hold a position until its expiration date.
Look again at the profit and loss above.
Notice the dotted line. This is the profit and loss two weeks before expiration. Note that at this stage the loss (dotted line below $0) is small and lower than the worst expiry point of $710. Also note that the upside has been gained up to this point. As the stock price rises above $710, the difference between the two lines becomes smaller.
This is the key to successful backspread trading. If you can get out of a position well before expiration, you can capture most of the upside with minimal risk.
Before we dive into how to exploit this, let’s take a look at the (very complicated) Greek word for backspread.
backspread greek
Let’s take a look at backspread options and how they affect your strategy. To illustrate this, let’s use the example of a backspread for an AAPL call.
delta
In most cases before expiration, the delta of the (call) backspread is positive (unless the underlying asset falls significantly when the delta is flat or slightly negative).
gamma
In the most important cases (as the basis increases) gamma is positive.
theta
Theta is the key risk in the backspread. As we’ve seen, inactivity becomes more costly over time. In other words, if there is no stock price movement, the backspread will incur a loss. It has positive theta. Over time, it becomes more positive. Therefore, avoid holding positions near expiration.
Vega
Vega is positive. As volatility increases, the value of your position increases.
This makes the call backspread the optimal backspread. If you make a bad trade and the stock price goes down (you’re hoping the stock price goes up), the volatility will also go up. This provides some protection as the position increases when Vega becomes positive. Volatility is a natural hedge.
Low
Given the short amount of time you plan to hold the position, rho is not a major concern.
The important point here is that you want the stock to move quickly after you place your position. If it doesn’t move, or if it moves in the wrong direction, we remove the trade before the theta decay affects us negatively.
Backspread adjustment
Overall picture of adjustment
At SteadyOptions, we don’t really like adjustments.
In general, adjusting a losing position in hopes of turning it around is similar to doubling down on a bad bet. Eventually, the losses will be too large to double. They tend to involve increased positions and risks. Possibility of disaster.
Backspread may be an exception
In any case, the backspread may be an exception. Losses on poorly performing positions remain small well before expiration, so it is possible to close the position with a small loss and then set the backspread at another (lower in the case of a call backspread) point is.
The important thing is that, as with adjustments, you only do this if you are willing to return the resulting position to its new state.
A good example is when a strong positive stock announcement was expected but has not yet materialized. Stock prices may have fallen while the market waited. However, we still believe an announcement is imminent and therefore want to adjust our position to continue to explore big moves. A call backspread adjustment makes this possible.
When should I consider adjustments?
Let’s use the call backspread example from 6.1. If you remember, about 30 days after expiration, he made his next trade with AAPL for $710 for $50 (and expects it to go up by the end of the month).
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Sold 1 AAPL September 710 call
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Buy 2 AAPL September 720 calls
Let’s say a few days later, AAPL drops to $700. As you can see from the profit and loss diagram, even if the stock price moves in the wrong direction, this is not a catastrophe.
Your “loss” on a trade could be as little as $5 to $10, or even less.
But the bigger problem is that the stock is moving away from the earnings zone (currently around $705 and rising further). Furthermore, to achieve profitability, the stock will need to pass through its trading high soon (around $710). This greatly reduces profitability if successful.
So what should I do?
Well, you can also delete trades with very small losses. And this is usually recommended. However, adjustments back to something resembling the original trade are very cheap in the early stages of the trade.
Possible adjustments
How should I adjust it? Simply delete the existing backspread and place another backspread centered at $690.
Remove the original backspread.
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Buy one AAPL September 710 call
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Sell 2 AAPL September 720 calls
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Earnings: $45
Set a new backspread.
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Sell 1 AAPL September 690 call
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Buy 2 AAPL September 700 calls
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Price: $50
The net cost is small ($5), but can be much higher when fees and slippage are taken into account.
This last point is important. You’ll need to weigh whether it’s worth adjusting the total cost. However, the process continues as before: Is it OK to create this position at this cost (including adjustment costs)?
Callback spread: trading plan
Finally, let’s put together everything we’ve learned so far to create a complete plan for call backspread trading.
Step 1: Choose your foundation
This is the key.
Apply a callback spread only if you think the stock price will rise quickly.
Step 2: Apply a call backspread “around” the current price
For example, let’s say you think EBAY will go up from its current value of $52.
You can sell 50 Ebay calls and buy 2 52 Ebay calls (with the same expiry date).
30-40 days out is best.
Step 3: Close if position falls or rises by 20%
Our goal is to get in and out of these trades quickly. And on average there are more winners than losers.
Step 3 (alternative)
If your position decreases by 20% with more than 20 days left to expire, you can decide to adjust.
If so (that is, you think the stock price will still rise), close your position and proceed to step 2.
(Be careful: with this method, you can only hope to recoup your losses. It’s best to do it only if you’re sure the stock will rise quickly and quickly.)
conclusion
In conclusion, backspreading can be an effective strategy for experienced options traders looking to profit from large price movements in the underlying asset while managing potential losses. By selling a certain number of call/put options and buying more call/put options at the same time, a trader can create a spread with unlimited profit potential.
However, it is important to note that backspreading is a complex strategy and requires a thorough understanding of options trading and market dynamics. Traders and investors should carefully weigh the risks and benefits, including the potential for maximum gain and loss, before incorporating this strategy into their portfolios. With the proper knowledge and risk management techniques, backspreading can be a valuable addition to a trader’s toolkit of options.
Another unique use of backspreads is as rate of return spreads.
About the author: Chris Young has a degree in mathematics and 18 years of financial experience. Although Chris is British, he has worked in the US and more recently in Australia. His interest in options was first sparked by the “Trading Options” section of the Financial Times of London. He decided to pass this knowledge on to a wider audience and in 2012 founded Epsilon He Options.
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