Call Backspread Options Strategy
Call backspreads, also known as call ratio backspreads, are an advanced options trading strategy used by traders and investors to profit from volatility in the market. This strategy involves selling a certain number of call options at a specific strike price and simultaneously buying a greater number of call options at a higher strike price. The goal is to create a spread that benefits from a large upward price movement in the underlying asset, while also limiting potential losses in case the market moves in the opposite direction.
In this article, we will take a closer look at call backspreads, how they work, and the advantages and disadvantages to consider before using them in your trading strategy.
What Is a Call Backspread?
A call backspread is a bullish options trading strategy that involves selling a lower strike call option while simultaneously buying a greater number of higher strike call options. It’s essentially a bear call spread plus an additional call purchased at the same strike price as the long call. All options in the spread have the same expiration date.
The sale and purchase of the call options may result in a net credit or debit, but usually, it results in a credit. The strategy offers unlimited profit potential if the underlying asset’s price increases significantly, specifically if it moves above the long call strike price. However, the maximum loss is limited and is calculated as the difference between the strike prices minus the credit.
Call Backspread Example
Let’s say the stock XYZ is currently trading at $100, and you believe it has the potential to increase in price, you could initiate a call backspread strategy by selling one call option with a lower strike price and purchasing two call options with a higher strike price.
Here’s an example of how the call backspread strategy could be implemented:
- Sell 1 XYZ $90 call option for $5 premium
- Buy 2 XYZ $110 call options for a total premium of $4.50 ($2.25 per option)
Overall, you would receive a net credit of $0.50 ($5 premium received from selling the call option minus the $4.50 premium paid for the two purchased call options).
Here are a few scenarios that could occur:
- The stock price rises above the long call strike price ($110), resulting in all the options being in the money and you would profit from the long calls, plus the net credit, minus the cost of closing the short call.
- The stock price is $110 at expiration, resulting in the long calls expiring worthless and you would profit from the net credit minus the cost of closing the short call.
- The stock price falls to or below the short call strike price ($90), resulting in all the options expiring worthless and you profit from the net credit.
How to Trade a Call Backspread
Here are the general steps for trading a call backspread:
- Identify a bullish market scenario: Call backspreads are most effective in bullish market scenarios where the investor expects the price of the underlying asset to increase significantly. Analyze market trends and technical indicators to identify potential opportunities for bullish trades.
- Select strike prices: Select a lower strike price for the call options that you plan to sell and a higher strike price for the call options that you plan to buy.
- Determine the number of contracts: Determine the number of call options to sell and buy based on your trading objectives and risk tolerance.
- Place the trade: Place the trade by simultaneously selling the lower strike call options and buying the higher strike call options. This will result in a net debit or credit, depending on the premiums of the call options.
- Monitor and manage the trade: Monitor the trade regularly and adjust the position as needed based on changing market conditions. This may involve rolling the options to different strike prices or adjusting the number of contracts to manage risk and maximize profit potential.
Trading a call backspread requires careful consideration of the investor’s risk tolerance, trading goals, and market conditions.
How to Adjust a Call Backspread
Here are a few ways to adjust a call backspread:
- Roll the spread: If the underlying asset price moves against the position, you may consider rolling the spread to a later expiration date or to a different strike price. This can help to manage risk and extend the trade’s duration.
- Add more contracts: If the underlying asset price moves in the expected direction, you may consider adding more contracts to the spread to increase potential profit. This can also help to lock in profits and manage risk.
- Close the spread: If the underlying asset price moves too far against the position, you may consider closing the spread to limit losses. This is especially important if the underlying asset price moves below the lower strike price of the spread.
- Adjust the ratio: You can adjust the ratio of the call options that you sell and buy to manage risk and maximize profit potential. For example, you can increase the number of call options that you buy relative to the number that you sell to increase profit potential, or decrease the number that you buy relative to the number that you sell to decrease risk.
It is important to remember that any adjustments made to the position may also result in increased transaction costs or reduced profit potential. Therefore, investors should carefully consider the potential risks and benefits of any adjustments before making them.
Pros and Cons of Call Backspreads
Here are some potential pros and cons of using a call backspread options trading strategy:
Pros:
- Unlimited profit potential: With a call backspread, there is no limit to the amount of profit that can be made if the underlying asset price rises significantly, making it an attractive strategy for bullish traders.
- Limited risk: The maximum potential loss for a call backspread is limited to the difference between the strike prices minus the net credit received, which provides a certain degree of protection against potential losses.
- Flexibility: Call backspreads can be customized to fit a trader’s specific goals and risk tolerance. This means that traders can adjust the ratio of options sold to options bought or select different strike prices to suit their individual preferences.
Cons:
- Complex strategy: Call backspreads are a complex trading strategy that can be challenging to understand for novice traders. A good understanding of options trading and market dynamics is essential to successfully implementing this strategy.
- Requires careful management: As with any trading strategy, call backspreads require careful monitoring and management to ensure that the spread remains profitable. If the underlying asset price moves in the opposite direction, the spread may need to be adjusted or closed out to limit potential losses.
- Potential for early assignment: When selling call options as part of a call backspread, there is a risk of early assignment if the price of the underlying asset rises above the lower strike price. This can result in the investor being forced to sell the underlying asset at a lower price than the current market value, potentially resulting in losses.
As with any trading strategy, investors should carefully consider the pros and cons and their individual risk tolerance before using a call backspread.
The Bottom Line
In conclusion, call backspreads can be a powerful tool for bullish options traders looking to profit from significant upward price movements in the underlying asset while limiting potential losses. By selling a certain number of call options at a lower strike price and simultaneously buying a greater number of call options at a higher strike price, traders and investors can create a spread with unlimited profit potential.
However, call backspreads are a complex strategy that requires a good understanding of options trading and market dynamics. Traders and investors should carefully consider the risks and rewards, including the maximum profit and loss potential, before implementing this strategy in their portfolio.
