The Backspread Options Strategy

The Smart Profits Report: Issue #274
Thursday, January 12, 2006

The Backspread Options Strategy - A Trade With Unlimited Profit PotentialBy Lee Lowell
Advisory Panelist, Mt. Vernon Research

Think you have a feeling that a stock or commodity is going to move big in a certain direction? Using options instead of the stock or commodity is a great way to leverage your money and cut down on your risk.

But what strategy should you use? Many people would simply buy a call or put option, or maybe even a straddle or strangle if they weren’t sure which direction it was going to make the big move. Although the problem these traders sometimes face is that they end up losing their option investment because they picked the wrong strike price or the wrong expiration, or just the fact that they had to pay out two premiums for a straddle trade.

I’ve got an options strategy that can potentially alleviate all of these symptoms, and it won’t cost you a dime to put on the trade. It’s called a “backspread,” and here’s how it works…

Buy Twice As Many Options As You Sell… And Pile On the Gains

The backspread is an option-spread type of play where you buy and sell different amounts of options on each leg. You will take in more premium than you shell out; hence, you will receive a credit at the beginning of the trade. The only downside to the backspread is that the stock or commodity MUST make the big move you anticipated, or else the position will start to slowly lose money.

The profit potential is unlimited, and if your market direction is completely wrong, you can still walk away unscathed. Let’s look at an example.

Backspread Options Strategy: Step 1 - Buying Calls

Let’s assume we’re bullish on IBM and we expect a significant up-move over the next year. Instead of buying 100 shares of stock that will cost us $8,400, we’re going to put on an option play in the form of a call backspread. This type of spread consists of more long options than short, but we’re going to sell option strikes that are in the money (ITM) and buy more options that are at the money (ATM).

A typical backspread is usually done in a 1 x 2 fashion. In other words, buy twice as many options than you sell. We always want to initiate the spread for a credit, which assures us of starting with money added to our trading account.

In our fictional trade, we’re going to sell five of the IBM January 2007 $70 calls for $17.90 (splitting bid/ask) and buy 10 of the January 2007 $85 calls for $7.60 (splitting bid/ask). This will give us a credit of $8,950 ($17.90 x 5 x $100) from the sale of the calls and incur a debit of $7,600 ($7.60 x 10 x $100) from the buy side, for a net credit into our account of $1,350 (a $8,950 credit minus a $7,600 debit). Now we sit and wait.

Here’s a breakdown of our potential profit/loss scenario at option expiration in January 2007:

Backspread Option Strategy - P/L scenario

Our break-even point, or where we start to make money on our spread, is somewhere between $95 and $100, as seen in the “Net P/L” column. That means we need IBM to go up at least another $13 over the next year to break even on the trade. Once we get above that level, our profits start to add up rather quickly. Since we’re very bullish, this type of trade can work extremely well if our prediction is right.

One great thing about the backspread is that if we’re completely wrong about our price prediction and IBM tanks below $70, we’ll still make money by keeping our initial credit of $1,350. The only time we’ll run into a problem is if IBM stays right around its price of $84 throughout the trade.

If you look at the P/L spreadsheet, you’ll see that our greatest potential loss is right around the $85 mark. So, in order to use proper money management, we want to be out of the trade somewhere within the last few months before expiration. If IBM is not making the anticipated move by that time, we’ll most likely be able to come out unscathed as spreads usually take the full time allotted to reach their maximum loss or profit potential.

The backspread is a great trade if you’ve got a real good feeling of a large directional move. You get to initiate the trade for a credit, and have lots of time to wait for the trade to mature. Even if you’re completely wrong in your directional assessment, you may still come out ahead in the profit/loss column. Remember, if the trade is not working for you by the last few months before option expiration, think about unwinding the trade.

Today’s Smart Profits Cribsheet

Need an explanation of a straddle or strangle from above? Check out Smart Profits #260, Two Ways to Profit Trading Index Options and Smart Profits #257, Extracting Three Strangle Tips From a 515% Gain.
For definitions of words like “leverage“or “backspread“, you can also visit the Smart Profits Glossary.
If you haven’t had a chance to look into my special electronic report, How to Receive Instant Cash Payments for “Locking In” Lower Prices on Your Favorite Stocks, now is a great time to do so. It outlines specific techniques I picked up in my seven years on the floor of the New York Mercantile Exchange. It’s a handbook we can e-mail right to your inbox… Click here to learn more.