Sitting On Your Hands? Consider Call Backspreads

The tech markets look like they are in a complete nuclear meltdown. All the way to China. I think it has everyone in a dejected silence – especially advisors who have called the bottom once or twice already and been proved wrong.

But that's what true bottoms feel like, I suppose. Everyone gets disgusted and dumps. Willing buyers are too scared to step in. Is there an appropriate option strategy if you think this might be the bottom, but are too fearful to put your toe in the water?

Yes there is. It’s called a backspread. Done using calls, you can set yourself up to profit handsomely if the techs rebound, but at the same time lose very little if they go to half price again.

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), but at a farther out-of-the-money strike.  A 2x1 ratio is most common.  Normally you try to select the options in such a way that the options you short bring in as much credit as the options you buy, so that the net cash flow of opening the position is nearly zero.

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 “pays 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.

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’s if the underlying moves in a small way in the desired direction.

I’ll illustrate using call backspread in Emulex (EMLX | Quote | Chart | News | PowerRating), a profitable, high quality company that many don’t think should have had its stock price cut in half the day they announced that some their customers were deferring orders. (Note: Backspreads can be constructed in puts just as well as in calls. Put backspreads behave in a mirror image fashion to call backspreads.)

 Figure 1

This particular 5x8 backspread costs $5,990 to put on.  (The cost of a backspread arises from the collateral requirement for a 1x1 credit spread plus the cost of the extra calls purchased.)  Note that this position loses money when Emulex is below 65.  However, it is very difficult to lose all your money, as Emulex would have to finish precisely at 45 (the long leg’s strike price) on expiration day.  (Contrast this with simple option buying – where it is very easy to lose all your money!)

Big profits can be made if Emulex moves above 65. Below 35, you lose only $990 no matter how far Emulex may fall.

Noteworthy is the outstanding risk/reward characteristic of the T+74 line (the dashed line), representing the halfway point in the life of this position.  If the expected price move happens within this time frame, you’re golden.  If not, you may consider closing the position at this time for just a small loss.

A Variation

By fiddling with the ratio of calls bought to calls sold, it’s easy to construct a backspread that produces a credit when you put it on. Then your purpose in using a backspread might be completely different. 

Do you think that tech stocks are likely to sink further?  See Figure 2 for a position that probably should be considered bearish, as it makes money from the current price on down, and only a really big move to the upside would bring in a profit again.  It was constructed by selling 10 near-the-money’s and buying 12 out-of-the-money’s. This $4,000 investment makes $1,000 if you’re right about the market going down, which is not bad.  Your whole $4,000 may be lost right at QQQ=56 on expiration day (not likely), and again the T+56 (dashed) line looks very good and might cause you to favor an early close.

 Figure 2