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Sitting on your Hands? Consider Call
Backspreads By Len Yates – President, OptionVue Systems International.
The tech markets looked like a they
were in a complete nuclear meltdown over the past year or two. 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.
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 only a small way in the desired direction.
I’ll illustrate using a call backspread in Scientific Atlanta, the nation's No. 2 maker of digital cable television set-top boxes. The next one or two quarter could be difficult because the first few months of the year are typically weaker for cable operators, and because average selling prices of set-tops are continuing to decline. Still, it is a top quality company and cable operators are ramping up their rollout of advanced services. (Note that backspreads can be constructed in puts just as well as in calls. Put backspreads behave in a mirror image fashion to call backspreads.)
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This particular 5x15 backspread cost $2,289 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 SFA is between 25 and 32.
However, it is very difficult to lose all your money, as it
would have to finish precisely at 30 (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 it moves above 32. Below
35, you still make $218, no matter how far Scientific Atlanta may
fall.
Noteworthy is the outstanding risk/reward characteristic of the
T+24 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, consider closing the position at this time for just a small gain or
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 15 near-the-money’s and buying 30
out-of-the-money’s. This
$4,888 investment makes $1,128 if you’re right about the market going
down, which is not bad. Your
whole $4,888 may be lost right at QQQ=43 on expiration day (not likely),
and again the T+56 (dashed) line looks very good and might cause you to
favor an early close.
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* Option strategies carry inherent risk of large potential
losses. As such, these strategies may not be suited to every
investor.
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