The Value Line Daily Options Survey

Backspreads in Today’s Market

With most stocks down 20% or more over the past month, heavy put buying has created many premium selling opportunities in the lower strike prices. In this week’s report we show how you can take advantage of these overpriced premiums to set up bullish call backspreads. These spreads can offer full protection on the downside plus strong nearterm profit potential on the upside. However, the backspread does have some peculiar risks and is therefore not the “Holy Grail” of option investing.

A Look at Norfolk Southern

Norfolk Southern (NSC), like many stocks, has seen its share price decline sharply these past several months, having traded as high as $75 this past August. At the time of this writing, it traded at $57.33. NSC has a Timeliness rank of 1 in the Value Line Investment Survey.

In Graph 1 below, we compare the implied volatilities of the January puts and calls on NSC for all strike prices with Value Line’s adjusted volatility forecasts for particular options. As with many stocks these days, what used to be a “volatility smile” pattern, with the strikes further from the stock price having progressively higher implied volatilities, now is a “volatility skew” with the lowest implied volatilities struck well above the current stock price.

Taking Advantage of the Pricing

With a call backspread, you can take advantage of this underpricing of the higher strike options and the overpricing of the lower strike ones. You do this by selling a lesser number of the lower strike calls and buying a greater number of the higher strike calls. The call backspread, like call buying, is a bullish position, offering unlimited gains if the stock increases. It is tricky to set up and we strongly recommend using Whatifi4.Xls, our position evaluation template, to test out the right strike prices and the right ratio of long calls to short calls. (You can download this template from our Excel Software directory. The report, “Whatifi4.Xls, Our New Position Evaluation Template,” Ot080602.Pdf, can be accessed in our Reports Archive.)

In our Figure 1 example below, we have written one slightly in-the-money January $55 strike call at $7.70 (credit $770) and we have bought three out-of-the-money January $70 calls priced at $2.05 each (total debit of $615). Thus, the entire spread was established at a net credit of $155, versus our estimate of a $107 debit.

Margins on Backspreads

Since the number of long options exceeds the number of short options, there are no “naked” short options in the backspread. For margin purposes, the exchanges view the backspread as a combination of “naked” long options and a credit spread. The net capital requirement on the backspread in our Norfolk Southern example works out to be the $15.00 difference between the two strikes times 100 minus the $155 net premium taken in. This comes to $1,345. Many investors like to use backspreads because they can apply their existing capital as margin without needing to ante up any cash.

Profit vs. Loss

In Graph 1 below, we show the profit and loss profile for stock moves of 40% in either direction. Here, we see the expected performance of the backspread on 10/29/08 (the day the trade was initiated), 30 days later (11/28/08), and at the January 17, 2009 expiration.

In looking at the graph, one should note that the call backspread is designed make a big short-term gain with only limited risk. The spread is not designed to be held until expiration. (The upside breakeven price at expiration is above $76). However, for the first several weeks after you establish it, the backspread can offer attractive rewards for its level of risk. Even after 30 days, there is some loss due to time decay, but even so, your likely maximum loss is only about $236.

Not the “Holy Grail”

Despite its attractive features, the backspread is not the “Holy Grail” of option investing. Looking at our example, notice that if the stock gets to the long calls’ $70.00 strike price and the options approach their expiration, the rate of time decay becomes fairly stiff. In general, if the stock moves in the direction of your option purchases, you should take your profits when you can and not wait for the spread to lose value.

Also, as with all spreads, establishing the initial positions can be expensive in terms of bid/ask spreads. Therefore, we urge investors to put a price limit on their spread orders. In our example, the spread was established at a $155 credit, which is kind of a “worst case” for the initial bid/ask spread. It would not have been unreasonable for the investor to establish this spread at a $170 credit using a spread order (see “Establishing your Spreads at the Best Prices,” Ot070917.Pdf).

In conclusion: due to their attractive margining features, backspreads can be a very costeffective alternative to “naked” option purchases. They are also relatively “risk-free” on the day they are put on, and for a limited period, thereafter. However, they have a limited life and require careful monitoring (see also “Finding and Setting up Backspreads,” Ot060612.Pdf).

Prepared by Lawrence D. Cavanagh
Editor, Value Line Options
vloptions@valueline.com