
Call
backspreads
are great
strategies
when you are
expecting
big moves in
already
volatile
stocks. The
trade itself
involves
selling a
call (or
calls) at a
lower strike
and buying a
greater
number of
calls at a
higher
strike
price.
Ideally,
this trade
is initiated
for a
minimal
debit or
possibly a
small
credit. This
way, if the
stock heads
south, you
won't suffer
much either
way. On the
other hand,
if the stock
takes off,
the profit
potential
will be
unlimited
because you
have more
long than
short calls.
To maximize
the
potential
for this
position,
many traders
use
in-the-money
options
because they
have a
higher
likelihood
of finishing
in-the-money.
Example
Using
International
Paper (NYSE:
IP), a
company that
historically
has been
quite
volatile, we
can create a
ratio
backspread
using
in-the-money
options.
In this
case, you
might buy
two of the
JUL 45 calls
at $1.05 and
sell one 40
call at
$4.00.
IP
Trading
@
$43.46 |
Buy |
IP
JUL
45
Call
@
$1.05 |
$210 |
Sell |
IP
JUL
40
Call
@
$4.00 |
($400) |
Credit
from
Trade |
($190) |
In this
case, you
would
receive $190
((4.00 -
2.10) x 100
shares) for
putting on
the trade.
If the stock
dropped
below $40,
you would
keep the
$190.
However, the
real money
would be
made if the
stock made a
huge move to
the upside.
The upside
breakeven
for this
trade would
be $48.10.
At this
price, the
40 calls
would be
worth $8.10
(8.10 x 1)
each while
the 45 calls
would be
worth $6.20
(3.10x2).
Factoring in
the initial
$190 credit,
the ROI at
this price
would be 0.
Above
$48.10, the
profit
potential is
unlimited. |
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Calculating the Breakeven
The easiest way to calculate
the upside breakeven is by
using the following formula:
Upside Breakeven = Long
strike price + [(Long strike
- short strike) x # of short
contracts] - net credit/100*
*(or + net debit)
Using the data for this
example, the breakeven
calculation looks like this:
45 + [(45 - 40) x 1] -
190/100
The maximum loss for this
trade would occur with the
stock at 45 because the long
calls would be worthless and
the short call would be
worth $5. Factoring in the
initial credit of $190, the
maximum loss on this trade
would be $310 (1 contact x
$5 x 100 shares - $190
credit).
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