The call backspread
strategy is an advanced options trading strategy that seeks to profit from a
significant move in a stock or underlying asset, usually in the upward
direction. It is especially beneficial when there is an expectation of higher
volatility. The strategy involves combining long and short positions in call
options and is designed to allow traders to gain from sharp price movements
while limiting potential losses in case of smaller or more gradual price
changes.
In this guide, we
will explore how the call backspread strategy works, when it is used, its
advantages and disadvantages, and examples to provide a comprehensive
understanding.
What is the Call
Backspread Strategy?
At its core, a call
backspread strategy involves buying more call options than you sell. Typically,
this is achieved by selling one call option at a lower strike price and buying
a higher number of call options at a higher strike price. For example, a common
configuration is to sell one call option and buy two call options at different
strike prices. The difference between the sold and bought options creates a net
debit or credit, depending on the strike prices and the premiums.
The strategy is
profitable in two primary scenarios:
If the stock price
rises significantly, the multiple long call options provide substantial
profits, as they increase in value.
If the stock price
drops significantly, the loss is limited due to the premium received from
selling the initial call option.
However, if the
stock remains stagnant or moves slightly upward, there is a potential for
limited losses. This is because the cost of the long calls may exceed the
premium received from the short call, leading to a small net debit or cost of
the position.
Key components of the
call backspread strategy:
Sell a call option –
The trader sells one call option with a
lower strike price. This generates a premium, which can offset the cost of the
call options that are purchased.
Buy multiple call options
– The trader buys a higher number of
call options at a higher strike price. The aim here is to capitalize on a large
upward move in the underlying asset.
Strike prices – The strike prices of the options used in the
backspread strategy play a critical role. The short call typically has a lower
strike price, while the long calls are at a higher strike price. This ensures
that the strategy is geared towards benefiting from a strong upward move in the
stock price.
Expiration dates –
All options in the strategy should have
the same expiration date. The backspread strategy is usually executed with
near-term expiration options since it aims to profit from imminent price
movements.
Net debit or credit –
The backspread can be entered either for
a net debit or a net credit. If the premiums of the purchased calls are higher
than the sold call, the position will result in a net debit, meaning the trader
has to pay to enter the position. If the premium received from the sold call is
higher than the cost of the purchased calls, the trader will receive a net
credit.
Example of a call
backspread strategy
Let’s assume that
stock XYZ is currently trading at $100, and you expect it to experience
significant volatility, potentially moving sharply upwards. Here’s how you can
set up a call backspread strategy:
Sell 1 Call Option with a strike price of Rs.105, expiring in
one month, for a premium of Rs.2.00.
Buy 2 Call Options with a strike price of Rs.110, expiring in
one month, for a premium of Rs.1.00 each.
Break even points
In this case, you would receive Rs.2.00 from selling the
first call option, but you will spend Rs.2.00 (2 x Rs.1.00) buying two call
options. This results in a net zero cost for the position. The goal is to make
money if the stock moves significantly above the Rs.110 strike price.
To calculate the
break-even points, consider the following:
The lower
break-even point is the price at which the premium received for the sold call
option covers the cost of the purchased call options. If the stock price falls
below this point, the strategy will break even or incur a small loss.
The higher
break-even point occurs when the stock price rises enough that the profit from
the long call options exceeds the loss from the short call option.
When to Use the
Call Backspread Strategy
A call backspread
strategy is most useful when:
You expect high
volatility. It is especially effective when you anticipate a sharp rise in the
stock price but want to limit losses in the event of a decline.
Bullish outlook –
Traders use this strategy when they are
bullish on the stock and expect it to rise significantly but want to maintain
protection if the price falls or does not move as expected.
Limited risk with
high upside potential – The strategy
offers limited downside risk, but the potential upside can be substantial if
the stock rallies beyond the strike price of the long call options.
Risks and rewards
1. Unlimited upside potential
The major
attraction of a call backspread strategy is its unlimited profit potential. If
the stock price rises sharply, the long calls can generate substantial profits,
as their value increases with the rising price of the underlying asset. There
is no cap on the potential profit.
2. Limited loss
The maximum loss
occurs if the stock price is between the strike prices of the sold call and the
purchased call options. In this case, the stock price does not rise enough for
the long calls to generate significant value, and the position results in a
small net loss. However, the loss is limited because the trader receives a
premium from selling the initial call, which offsets some of the costs of
buying the long calls.
3. Break-even point
A critical aspect of this strategy is
calculating the break-even point. There are generally two break-even points:
one below the strike price and one above. The trader needs to be aware of these
points to understand when the strategy becomes profitable.
4. Impact of time decay
Since options lose
value over time (due to time decay), the call backspread strategy can suffer if
the stock does not move as expected. The long call options will lose value as
they approach expiration, and if the stock price remains stagnant, the position
can lead to a loss.
Advantages of the
call backspread strategy
Limited risk – The maximum risk is known and is capped if the
stock does not move as expected. This makes the strategy safer than buying
outright calls, as the initial cost is lower.
Profit from large moves
– If the underlying stock moves
sharply upward, the call backspread can generate significant profits due to the
higher number of long calls in the position.
Flexibility – The strategy can be adjusted for different
risk and reward profiles by altering the ratio of sold and purchased calls or
adjusting the strike prices.
Disadvantages of the
call backspread strategy
Moderate movements
lead to losses – If the stock price
increases slightly but does not rise sharply, the strategy can result in a
loss. This is because the short call will incur losses, while the long calls
will not generate enough profits to cover the cost.
Complexity – The strategy involves multiple options and may
be difficult for beginner traders to understand and manage effectively.
Impact of time decay
– As expiration approaches, the long
calls will lose value due to time decay, making it crucial for the stock to
move early in the trade.
Conclusion
The call backspread
strategy is a powerful tool for options traders who anticipate significant
upward price movements in an underlying asset. It provides unlimited profit
potential while limiting losses, making it an attractive choice for traders
with a bullish outlook and a strong belief in future volatility. However, it
requires careful management, as moderate price movements and time decay can lead
to losses. Traders should fully understand the risks and break-even points
associated with the strategy before implementing it.
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