Option Strategies Details

A trader who wants to speculate on a large increase in price and an increase in volatility can open a Call Backspread. The trader may pay a small debit, receive a small credit, or even open the position for exactly $0.

Suppose stock XYZ is trading at $56. You forecast a large increase in XYZ price and an increase in volatility.

You open a 1x3 $55 / $62 Call Backspread (selling the $55 Call for a $4.20 credit and buying three (3) $62 Calls for $1.40 each) for exactly $0 to express this view. Your breakeven low XYZ price at expiry is any price below $55 (since you entered the position for $0 and all contracts would expire worthless). The high breakeven price is more complex to calculate but adheres to this formula:

(Width of Spread / (N - 1)) + Strike Price of Long Calls +/- Debit Paid/Credit Received

Where N is the number of Long Calls bought with the credit from the Short Call.

The high breakeven for this Call Backspread is $7 / (3-1) + $62 + $0 = $65.50. However, since the time component of your trade plan may not since the time component of your trade plan may not extend all the way to expiration you should be prepared to to close at a variety of XYZ prices as the market value of your 1x3 $55 / $62 Call Backspread changes.

The max loss on this position at expiry is the width of the spread ($62 - $55 = $7), which occurs if price is exactly the strike of the long Calls ($62). The max gain of a Call Backspread is theoretically infinite and grows rapidly if the price of XYZ exceeds the long Call strike, especially if that price increase occurs in advance of expiry. The PnL of a Call Backspread relies heavily on XYZ price increasing significantly, approximately 17% in this example, and can be very costly if XYZ price increases less than your forecasted amount.

Let's walk through another example, this time with a 1x2 Call Backspread, to solidify this "large price increase required" concept.

Suppose stock ABC is trading at $39. You forecast a large increase in XYZ price and an increase in volatility as well.

You open a 1x2 $40 / $45 Call Backspread (selling the $40 Call for a $3.40 credit and buying two (2) $45 Calls for $1.75 each) for a $0.10 debit to express this view. At expiry, if ABC price is below $40, you lose only the $0.10 debit paid to open the position. Your breakeven ABC upside price at expiry is $50.10 ($5/1 + $45 + $0.10 = $50.10), but since the time component of your trade plan may not extend all the way to expiration you should be prepared to to close at a variety of ABC prices as the market value of your 1x2 $40 / $45 Call Backspread changes. The max loss on this position at expiry is $5.10 (the width of the spread plus any debit paid or minus any credit received, $45 - $40 + $0.10 = $5.10), which occurs if ABC price is the same as the long Call strike of $45.