Backspreads: No Cost of Being Wrong

I’m a great believer in using the right tool for the job. The backspread is an amazing little strategy when you expect a potentially big price move, but at the same time you realize that there is a chance you could be wrong and no move whatsoever develops. One example when it would be appropriate to use a backspread might be when a drug company is approaching a deadline for FDA approval of a new product or around results or some major economic or geo-political event. Another good time to use a backspread is when bottom fishing near what you think is the end of a market sell-off.

A backspread is constructed by shorting a near-the-money option and buying a larger quantity of options of the same type (calls or puts) at a farther out-of-the-money strike. A 2 × 1 ratio is most common. Normally you try to select the options in such a way that the options you’re shorting bring in a sufficient credit to cover the cost of the options you’re buying, resulting in a net cash flow of nearly zero.

If all that sounds too good to be true, I’ll tell you what the catch is.There is a price zone where the backspread loses money. It occurs whenthe underlying moves in the desired direction by only a small amount.

For instance, in the current scenario if you think Infosys is a good stock to trade Long, you can go ahead and Short Infosys 580 Call at Inr 25/- and against that Long 2 X Infosys 600 Call at Inr 14/-. So, the cost of the strategy would be just Inr 3/-.

After a deep correction, the stock upmove can be significantly strong. The idea here is that we are betting on a sharp uptick in the stock. If the uptick does not fructify one can cover the Long Call and would still end up making some money. In a situation the stock stays below 580 there will be a loss of Inr 3/-. At 600 the loss will be maximum, which would be Inr 23/-. As the stock moves above 620, the strategy would start gaining.

Since in a backspread you are net long options, the profit potential is unlimited. At the same time, the sale of a smaller number of more expensive options effectively pay for the options purchased, with the result that if both legs of the backspread expire worthless, it costs you nothing. The short leg of the backspread also effectively eliminates time decay as a worry.

Happy Trading!!!

Cheers.