By Stan Freifeld, a market maker for options on several popular equities*
Posted: Sept 4, 2009

One of my favorite types of trades is called the backspread. It's another one of those trades with which you can make money in several different ways, but like every other trade and strategy that I know, it's not foolproof -- you can also lose money.

The nomenclature in the options industry is not precise, and, in the past, some serious mistakes have been made because of this. So, let's start the discussion with a definition:

Definition: A backspread is a delta neutral options position that consists of more long options than short options on the same underlying stock. Backspreads can be established with either puts or calls in the same expiration month. There is also a calendar or diagonal backspread, which has more options being bought in a far month than are being sold in a near month. Those spreads are not the subject of this article.

To make the backspread delta neutral, the ratio of long to short options is usually somewhere in the neighborhood of 2:1 or 3:2. Extreme ratios should be avoided. Let's look at an example of a call backspread, using my favorite hypothetical stock XYZ.

With:

• XYZ @ 100
• The Sept 90 Call @ $12 with a delta of 80
• The Sep 100 Call @ $6 with a delta of 55

If we sell 5 of the 90s and buy 7 of the 100s, we'll have a position that is net short 15 deltas, which is close to delta neutral. It's calculated as follows: -5 x 80 + 7 x 55 = -15.

Also note that the net cost of putting on this position is a credit of $1,800, calculated as -5 x $1,200 + 7 x $600 = -$1,800.

At expiration, the graph of this position will look like this:

(I think it would help you to understand this topic if you could draw a graph of a put backspread.)

Three things become immediately apparent when looking at this graph:

1. There is unlimited gain potential on the up side.
2. There is limited gain potential on the down side.
3. The worst place for the stock to end up at expiration is where the 2 diagonal lines meet, which is the strike price of the long options.

From the graph, it looks as though the breakeven points (where the graph crosses the horizontal axis) are approximately $94 on the down side and approximately $115 on the up side.

Let's see if we can determine exactly where these breakeven points are. We know that, at $90 or below, both the 90 and 100 calls are worthless, so we keep the credit of $1,800. As the stock price goes up from $90 toward $100, the 100s will still be worthless, but the 90s will be losing $500 / point because we are short 5 of them. If we take the $1,800 credit and divide it by 500, we see that, if the stock moves up 3.6 points (1800 / 500) to $93.60, we'll be at exactly breakeven.

If the stock continues to climb to $100, we will have lost a total of 10 points (from 90 to 100) 5 times or, $5,000. But, we had the initial $1,800 credit, so the maximum loss is $3,200.

Things get better from this point. For every $1 increase in stock price, the position is now gaining $200. So, the upside breakeven point is going to be 16 (3200 / 200) points higher than $100 or $116.

I went through this in some detail because I get many email messages from readers asking me how to calculate the breakeven points of a spread. Keep in mind that this is just basic arithmetic, nothing fancy. We could also notice from the graph that it looks similar to a ratioed straddle. The difference, of course, is that there is not unlimited gain on the down side. On the other hand, the cost is much less, and in this case, it is being put on for a net credit. It's not always possible to get a credit when putting on a backspread, and, so, sometimes, they're done for a small debit.

What else can we determine about backspreads? Let's look at the Greeks:

Price -- This one is easy; we put the position on delta neutral, so we know a small move up or down in the price of the stock should not have much of an impact on the value of the spread initially. However, the gamma of the position is positive, indicating that a large move in the price helps the position.

Time -- This position has negative theta, so time is working against you. That implies that you might not want to put this position on close to expiration.

Volatility -- This position has positive vega, so an increase in IV is helpful. Also, since the crash of 1987, most index options and many stock options exhibit a reverse (or negative) vertical skew. That means that the lower strikes trade with a higher IV than the higher strikes.

When putting on a call backspread, that is exactly what we want to do: Sell the higher IV and buy the less expensive IV. This is also the reason that put backspreads have lost some of their appeal and have gone out of favor. A put backspread would require you to buy the expensive IV and sell the cheaper IV, which is not recommended.

Now, we can put it all together and see when it makes sense to use the call backspread; you:

• Want a situation where you're very bullish on a stock and expect a large move. (A large move to the down side is better than no move at all.)
• Want to go out at least 2 months and up to 5 or 6
• Are expecting the IV of the options to increase
• Want to put the position on for a net credit or a very small debit

If these conditions are met, the backspread will have a high probability of success. It is a common and useful strategy and one that you should become familiar with.

*Reprinted (and modified) with permission from Online Trading Academy (www.onlinetradingacademy.com). Stan Freifeld can be reached at: sfreifeld@tradingacademy.com.