The ratio backspread is a strategy which typically sells one “in” or at-the-money call or put while purchasing a greater quantity of “at” or out-of-the money contracts in the same expiration cycle. Most often packaged for a credit, the trader will collect that premium in full if shares of the underlying are positioned as to keep the sold strike out-of-the money at expiration. For a call backspread this would mean shares are below the lower sold call(s) and above the sold strike if one is using puts.
Cashing in on a credit is a nice profit perk but the real enchilada or maybe apple comes if shares bolt through the purchased strike of the backspread. Being a net long contract spread, the position will benefit from a directional move which allows the deltas of the purchased calls or puts to go in-the-money. An increase in implied volatility will most often generate greater returns for the position, while theta risk, as the spread closes in on expiration; will act as a drag on potential profitability. I like to personally think of the backspread as the poor man's long straddle, when the trader also maintains a directional bias rather than just expectant of a large move in either direction.
Figure 1: SP-500 (SPY) Backspread (1) x 3 March 135 / 139
Shown above is a (1) x 3 backspread in the SP-500 from Feb 13. The combined “at” and out-of-money positioning and ratio yields a very small $0.10 credit or $10 total below 135. As the amount barely covers lunch at the deli counter and as is easily visible; this position is rooting for some quick and strong upside in order to enjoy a much nicer and pricier dinner later on.
Another use of the backspread is for an adjustment. For instance, when a trader has an existing long call position with open profits, would like to reduce that exposure in the event of a move to the downside, but also wishes to maintain directional exposure in an attempt to ride a price trend still in motion, even further, the backspread, might be considered as an alternative hedging strategy. In this situation, the backspread order is actually transferring a lesser quantity of calls at a lower strike for a greater number of contracts on a strike that’s “at” or out-of-the money.
To illustrate, let’s look at Apple (AAPL). Suppose on Jan 31 and shortly after earnings, a trader decides to purchase two “OTM”, 20 delta March 485 calls for $3.60. The rationale is implieds have come in and look reasonable following the report, shares have just made a fresh marginal closing high from a small consolidation and the carrot or umm apple of $500, is dangling above to temp bulls into a position.
Figure 2: Apple-to-more Apples Comparison
Following the long call purchase and just several trading sessions later on Feb 10, Apple has nearly fulfilled a test of $500. Shares that day climbed to nearly 498 before backing off into the close to finish near 493 in a doji decision candle. Given the run about 8%, weekend holding risk and what could amount to as a “close enough for government work” situation, the trader wants to take the massive open ROI of nearly 500%, reduce the risk of giving it all back while remaining positioned for continued upside, should the powers that be, decide “close enough” isn’t going to cut it and the stock ultimately runs even higher.
Shown above, we’re looking at one possible backspread adjustment which sells the 2 March 485 calls “to close” for $21 per contract and uses a portion of the proceeds to purchase 3 March 515 calls for $8.50 apiece. In the event Apple shares turn red and less-than-Delicious, the trader would still pocket $930 below 515 at expiration and have the opportunity to make a good deal more above the strike. Prior to the third Friday in March and still 35 days out, were shares to continue higher the position is now net long 3 contracts and potentially 300 deltas versus the original 2 lot.
Also depicted is a simple adjustment of selling half and riding the balance. In this case the sale of one contract leaves the trader long 1 March 485 call with a guaranteed profit of $1,380 above the strike and the ability to make $100 for each point AAPL is above the strike. With this method, we can also see the held 1 lot would provide much less profitable on a continuation of price strength from AAPL shares prior to expiration. Which strategy is better you ask? Well, given our apple-to-more apples comparison, that’s kind of like choosing between different varieties of apples. Both are ultimately good for your health, but one might be more pleasing to the eye and taste based on sometimes changing preferences.
Chris Tyler
Senior Options Writer, former Market Maker & fulltime Option Hedge Hog Advocate
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The information offered here is based upon Christopher Tyler’s observations and strictly intended for educational purposes only, the use of which is the responsibility of the individual.
