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This week, we examine the "backspread", an options combination in which the investor buys a certain number of options with a particular strike price and writes a lesser number of options at a strike price that is more deeply in-the-money. The backspread tends to give the investor unlimited profits if the stock's movement favors the bias of the long options, and a finite gain if the stock moves the other way. One advantage of the backspread is that it often can be established at a credit. Another advantage is that over a limited period of time after it is established, it can provide very attractive profit potential with relatively little risk. Backspreads, however, are complicated and not without pitfalls. You should analyze each backspread carefully before you establish it and then monitor it carefully once you have put it on. To do this, we recommend that you use our option position analyzer, Whatifi3.Xls.

Same Expiration, More Longs than Shorts

With a call backspread, you buy a greater number of higher strike (lower delta) calls and sell a lesser number of lower strike (higher delta) calls with the same expiration. With a put backspread, you buy a greater number of lower strike (lower delta) puts and sell a lesser number of higher strike (higher delta) puts, again with the same expiration. Call and Put backspreads are essentially mirror opposites, so for purposes of this report, we will only focus on call backspreads. Keep in mind, though, that the backspread is usually set up as an alternative to "naked" option purchases. The call backspread, like call buying, tends to be bullish, offering unlimited gains if the stock increases. The put backspread tends to be bearish, offering unlimited profits if the stock decreases.

Setting One Up

As mentioned above, it makes sense to use Whatifi3.Xls when setting up a backspread. Subscribers can download this template from our Templates Archive. The report, "Introducing Whatifi3.Xls," Ot050215.Pdf is available in our Reports Archive. Here is an example using options from calls as of June 20, 2005. With Whatifi3.Xls, we set-up a backspread example in which we bought three out-of-the-money Eastman Chemical September $60 calls at $1.60 each and wrote one in-the-money September $50 call at $7.60. The Eastman Chemical common was trading at $56.85. Looking at the right hand side of Figure 1 below, we see the amount of premium paid out to establish this position is minus $280 - i.e. a net credit of premium. That is a total premium paid out of $480 (300 x $1.60) and total premium taken in of $760 (100 x $7.60). This $280 credit is before payment of commissions. However, the analysis in the graph does reflect the bid and ask spread. Notice that this $280 credit is a good deal less than our model's estimate of a $62 net credit. In this example the calls we bought were underpriced and the call we wrote were overpriced, according to our model.

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Margins on Backspreads

Since the number of long options exceeds the number of short options, there are no "naked" short options in a backspread. Rather, there are a certain number of long options combined with a credit spread. The Exchanges view the backspreads as a combination of "naked" long options and one or more credit call spreads. The net margin on this bear call spread component works out to be the difference between the two strikes times 100, minus the net premium taken on this bear call spread. This would come to comes to $400 ($1,000 minus the difference between $760 for the option written, and $160 for the long option). Many investors like using backspreads because they can use their existing capital as margin without having to ante up any cash.

"On the day you establish it and for a limited period, a backspread can offer very attractive profits for relatively little risk..."

Profit vs. Loss

In Graph 1, we show the profit and loss profile of the example for a stock move of 50% in either direction. Graph 1 shows the expected performance of the backspread on June 20th (the day the trade was initiated), 30 days later (7/21/05), and on the September 17, 2005 expiration date. Notice that although the breakeven points at expiration might not look that favorable, on the day you establish it, the spread has relatively low risk. After 30 days, there is some loss due to time decay, but even so, your likely maximum loss in this example is only about $175.

Trying Out Different Combinations

Due to its very attractive margining features, backspreads can be a very cost-effective alternative to "naked" common stock purchases. They are also relatively "risk less" on the day they are put on, and for a limited period, thereafter. However, they have a limited life and require careful monitoring. To do this, we advise that you use our Whatif3.Xls. Subscribers who want to read up on our new and much improved version of should see "Introducing Whatifi3.xls," (Ot050214.Pdf) in Options Reports.