Options backspreads are trading strategies, which have the aim of benefiting from volatile markets. In this context a volatile market is where a sharp price increase or decrease is expected. Typical examples of such a situation is just before publication of financial
statements, major news releases or court cases.
Backspreads are able to profit whether the market price of the underlying asset goes up or goes down, as long as this movement is significant. If the price remains stagnant or in a narrow range, the options backspread trader will typically lose a limited amount of money.
A backspread could, however, still make money in a stagnant market if the volatility of the underlying asset price increases sharply. This is why those who favour backspreads usually enter the trade relatively long before any major announcement from that particular company is expected; their aim is to ‘ride the volatility wave’ all the way to its end.
Examples of backspreads
Below we will discuss a few examples of backspreads.
The long straddle
The simplest yet still one of the most popular backspreads is no doubt the long straddle. Fig. 8.31 (d) below is an example of a long straddle, consisting of a long ATM put and a long ATM call.
From the above chart it is clear that the trade will:
a) Be profitable if the underlying asset price moves sharply up or down and
b) Make a limited loss if the price remains stagnant or within a narrow range
The long straddle is a debit spread, i.e. it will cost the trader money to enter this trade. Below we will discuss another options backspread, the call ratio backspread, which is a credit spread.
The call ratio backspread
The call ratio backspread is similar to the long straddle in the respect that it will be profitable whether the price of the underlying moves sharply up or down. It has unlimited profit potential to the upside and limited profit potential to the downside. If the price trades within a narrow range up to the expiration date, the trader will make a limited loss.
Fig. 8.31(e) below is a graphical illustration of the call ratio backspread.
This trade is entered into by buying more ATM or OTM call options than the number of ITM call options that are purchased.
The share price of Company ABC is trading at $91. A call ratio backspread can be entered into by selling 1 contract of $87 call options (ITM) and simultaneously buying 2 contracts of $91 call options for the same expiration date.
Since the ITM call options are more expensive than the ATM calls, the trader should be able to enter this trade for a net credit, i.e. without parting with any money upfront.
If the price of the underlying asset moves sharply downwards the trade will profit with the amount of the net credit; if it moves sharply upwards the trade has an unlimited profit potential and if the price remains stagnant the trade will make a limited loss.
Backspreads are best for when sharp price changes are expected. If Murphy’s Law results in a stagnant price, the trader could lose a substantial amount of money. Fortunately this can be calculated before the time to determine whether the reward/risk ratio makes for a sensible trade.