Monday, May 9, 2011

Options 101: The Call Backspread

A back spread, or ratio back spread, is a bullish spread that consists of selling a number of call options and buying more options of the same underlying stock with the same expiration date at a higher strike price. In other words, a back spread has more long contracts than short contracts. When reading this type of spread, the lower strike is generally stated first, whether it is long or short. Back spreads are very flexible, and can be executed for debits, credits, or even money when there is no debit or credit.

The back spread profits when the underlying stock price makes a move to the upside toward, through and beyond the long strike. The call back spread has limited risk and unlimited profit potential. The bigger the ratio of short options to long options, the more risk involved.

Since there is no specific ratio for back spreads, the Greeks may act differently according to the ratio or where the stock price is relative to the strike prices of the long and short options. The delta of a back spread is generally dominated by the option with the greater quantity the further it is from expiration. Vega in a back spread is generally dominated by the long options the more time there is to expiration and the closer the stock price is to the strike price of the long options.

It is also interesting to note that the back spread is one option away from being a butterfly. Understanding this can be very useful  when trading butterflies or back spreads.

The graph above is an example of a Netflix June $255/$260 1x2 back spread. This back spread is executed for a debit of $2.45. As you can see, the max risk occurs at the higher strike price, and the profit potential is unlimited. 

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