What is a Option Backspread?

Option Backspread

A long Backspread involves selling (short) at or in-the-money options and buying (long) a greater number of out-of-the-money options of the same type. The option that is sold should have higher implied volatility than the option bought. This is called volatility skew. The trade should be made with a credit. That is, the amount of money collected on the short options should be greater than the cost of the long options. These conditions are easiest to meet when volatility is low and strike price of the long option is near the stock price.

Risk is the difference in strikes X number of short options minus the credit. The risk is limited and maximum at the strike of the long options.

Let's look at a long call backspread trade. On July 26, 2006 we entered a call backspread on ATI Technologies, Inc. (ATYT) by selling 10 Nov $15 strike call options and buying 19 Nov $20 strike call options. ATYT closed at $19.71 the day before. The $15.00 strike call that was sold had a premium of $5.00. The $20.00 strike call that we bought was $0.70. Implied volatility on the $15 strike call was 25.88% and the $20 strike call was 15.10%. Note the skew in implied volatility. The profit graph for this position is shown below.

Note that there is unlimited profit to the up side due to the greater number of $20 strike calls bought. The credit on this trade is $3,670.00 and maximum risk is $1,330.00. Upside breakeven is at a stock price of $21.48 and downside breakeven is at $18.66. Since we are short some options, a margin is required on this trade. This margin can vary between brokerage companies but should never be greater than the maximum risk.

Since these trades are entered with a credit, the trade report shows the probability of retaining a percentage of that credit. For a percent retained of 20%, this would be $734.00 on this trade ($3670 x 0.20 = $734).

We calculate the probability of retaining 20, 50, 100 and 200% of the credit on backspread trades we test each night. If the 20% level probability is 95% or greater we recommend the trade. The percent retained we target is 10%. After 10 days in the trade, we bail out at break even or any profit. On backspreads we limit total risk to about $3000.00 per trade. Using our trade management tool, you can test your own method to manage trades.

In the case of this ATYT trade the probability of profit at 20% was 96.92%, 50% was 58.11%, 100% was 15.34% and 200% was 3.90%. Since 20% retained credit level's probability was greater than 95%, we took the trade and targeted 10% of credit retained.

On the morning of July 26, 2006, the options were actually priced at $5.20 for the $15 strike calls and $0.80 for the $20 strike calls. The total credit on the trade was $3,680.00 and 10% of that credit is $368.00. The trade was closed two days later with profit of $660.00 or 17.9% of credit retained.

Now we will look at an example of a Put Backspread. On January 24, 2006 we entered a put backspread on The Goodyear Tire & Rubber Company (GT) by selling 10 Apr $20.00 strike put options and buying 16 Apr $17.50 strike put options. GT closed at $17.96 the day before. The $20.00 strike put that was sold had a premium of $2.40. The $17.50 strike put that we bought was $0.90. Implied volatility on the $20.00 strike put was 36.28% and the $17.50 strike put was 35.37%. Again, note the volatility skew. The profit graph for this position is shown below.

Note that there is nearly unlimited profit to the down side due the greater number of $17.50 strike puts bought. I say nearly because the lowest the stock can go is zero. You should notice that this profit graph is a mirror image of the call backspread profit graph.

This trade was actually entered with a credit of $960.00 and was closed on January 30, 2006 with a retained credit of $210.00 or 22% of entry credit.