A call backspread options strategy has multiple legs, is bullish in nature, the risk is
defined, and profit is unlimited. The strategy benefits from the huge rise in the
underlying stock price.
Call backspreads are majorly made up of three components; one is the short call
option which is sold in-the-money and below the current stock price, and the other
two components are the long call option bought out-of-the-option at a higher
price. Traders must check that all three options must expire on the same date. Call
backspread is open for debit and credit based on the price and its movement.
Generally, traders open it to receive credit. The strategy benefits from the large
upwards movement, and a good thing can also benefit the trader if the stock moves
downwards.
Call backspread strategy from the market's perspective:
When the trader believes that the market is bullish and the underlying stock price
will increase above the long call options at the time of expiry, the potential to make a
profit above the long call options is limitless. If the price is slightly increased, it would
not be a good scenario; the stock has to face a significant movement. If the stock
price decreases, the risk to the trader is very limited. Suppose the trader has opened
the call backspread for the credit; the position makes a profit if the price falls.
How can I set up a call backspread?
A call backspread is made up of three components, as discussed earlier. Traders can
sell-to-open (STO) one short call, which is in-the-money and buy-to-open two long
calls above the short calls options. The ratio of the contract must be maintained in a
way where the long call options purchased are more than the short calls sold.
For example: If traders sell one short call, they must buy two long call options
against that. Suppose the trader has opened the position for credit, and if the stock
closes at the strike price of the long call option at the time of expiry, then he may incur
a maximum loss, as the short call options must be in-the-money, and long ones will
expire worthlessly. The highest profit potential is when the stock goes beyond the
long options.
The debit payment or receiving of the credit mostly depends on how far in-the-money
short-call contracts are and how far out-of-the-money long-call options are in
relation to the underlying stock price.
Understanding the call backspread diagram:
The diagram of the call backspread, which is opened to receive the credit, would look
like a V shape; in this V shape, the left side represents the credit amount received. Risk
is predefined while entering the strategy, and traders get the maximum profit on the
upside. The highest loss to the trader is the total width spread minus credit received
while entering. Traders face the maximum loss if the stock closes on the strike price
of the long call option at the time of expiry. In this case, short-call options contracts
will be in-the-money, and long calls will be left with zero intrinsic value.
Suppose the underlying stock price closes below the short call at the time of expiry.
In that case, all options will expire worthlessly, and the credit received while entering
the strategy would be the only profit to the trader. If the stock price closes higher than
the long call options at the time of expiry, then all the options will expire in-the-money,
and the trader must close the position to avoid execution and loss. The long calls will
still have some intrinsic value left at the time of expiry. The total net profit to the trader
would be the width spread between the bear call spread plus or minus the cost of
entering the strategy will be the net profit or net loss.
For example: If the stock is currently traded at Rs. 48, and if the trader believes
the underlying stock will go upwards and close at Rs. 50, then the trader may enter
the call backspread by sell-to-open (STO) one short call at Rs 45 and purchasing
Buy-to-open (BTO) two call options at Rs. 50. Now, if the call option worth Rs 45,
receives the credit of Rs. 5 and two call options worth Rs. 50 costs the trader Rs.2 to
enter the position; the position will create Rs.1 credit while entering. If the stock closes
below Rs.45 at the time of expiry, all three call option contracts will expire worthlessly,
and the only profit to the trader will be Rs. 100 received initially. If the underlying stock
expires at Rs.50 at the time of expiry, then the two long calls of strike price Rs. 50 will
expire worthlessly, and short call options will incur additional Rs. 5 to close the position.
The Rs. 5 expense to close minus Rs. 1 initial credit received will be the total loss to the
trader on this position (total loss is Rs. -400).
Suppose the stock closes above Rs. 50 at the time of expiry, then the profit or loss can
be calculated as below: the price difference between the stock price and long call
price, multiply the number of long contracts, adding the initial credit received, and
deducting the intrinsic value of in-the-money short options. The amount a trader gets
will be the net profit or net loss.
Understand with an example: Suppose the stock closes at Rs.50 during expiry, then
the trader will have a net loss of Rs. -200. The long call will be Rs. 2 in-the-money, and
the short call options will also be Rs. 7 in-the-money. The profit from the long calls
will be Rs. 400(Rs. 2 ITM X 2 Contracts) + Rs. 100 credit received totals Rs. 500. But the
trader needs to close the short call at Rs.7, and the total cost would be Rs. 700, so if we
calculate the net profit/loss here, the trader earned Rs. 500 and paid Rs. 700; thus -200
is the net loss.
In this strategy, there are two break-even points:
The short call strike price + credit received
The short call strike price + (difference between the strike price X 2) - initial credit.
Considering the above example, these two break-even points are Rs. 46 and Rs. 54.
If the stock closes beyond the upper break-even point, the trader experiences
unlimited upside profit.
How can I enter the call backspread?
The call backspread is a bear credit spread, having one additional call bought at the
same strike as the long call. All the options will have the same expiry date.
For entering into the call backspread, traders have to sell-to-open (STO) a short option
and buy-to-open (BTO) long call options contracts. Long call options must be higher
than the short call options, even being the bear call spread, this strategy is bullish.
The diagram of the call backspread looks similar to the single-long call. The only
difference is that this diagram has an extra opportunity to profit on the downside if
sold for credit. The bear call spread brings down the price of extra long-call options
and reduces the overall risk by receiving additional credit.
Call backspread can be bought for debit or sold for credit. The width of the spread
will decide the price while entering into the strategy, based on how far-in-the-money
the short calls contracts are and how far out-of-the-money long options are in relation
to the stock price.
How can I exit from the call backspread?
To get the maximum profit, there must be a significant move in the underlying stock
price above the long call strike price. If the stock closes above the long calls during
expiry, then all three options contracts will be in-the-money, and the traders must
exit to avoid their execution. Suppose the stock closes above the short calls during
expiry, then the contract will be in-the-money, and traders must close the position
to avoid the risk of assignment.
The position's profit potential and overall risk are decided upon entering the strategy.
If the stock is below the short call options, all the contracts will expire worthlessly, and
traders need not take any action; the credit received by the trader initially will remain.
The impact of time decay on the call backspread:
This strategy is a net long position strategy; hence time decay factor or theta works
against the strategy. With each passing day, the value of the options contracts
decreases, which will negatively affect the value of the other two long call options.
Impact of implied volatility on the call backspread:
Traders take advantage of the high implied volatility rate in the call backspread
strategy. Higher the volatility, the higher the premium prices. Generally, when traders
enter this strategy, the volatility is low compared to the time of expiry or exiting the
trade. To get the maximum profit, the strategy relies on long options contracts.
Although future volatility or Vega is difficult to predict, it might help if you know its
impact on the position and contracts.
How to adjust the call backspread?
Call backspreads have limited time to make a profit. Suppose the trader has entered
the call back spread for a credit, then the risk is very limited, and backspreads are not
adjusted. Traders may roll the stock up or down to get the contracts into the profit
zone. There is at least one short contract involved in the call back spread. So, if you
execute it before expiry, it may be risky.
Traders should consider external factors such as dividends while deciding to adjust
or to close the call backspread position. Suppose traders wish to extend the trade to
let the contracts into profit zones or avoid execution of the contracts, then they must
close the entire position and re-open for some future expiry date. The new position
can be opened with the same strike price or new strike prices based on the current
price movement of the underlying stock.
How to roll a Call Backspread?
The call backspread must close above a certain price at the time of expiry to get the
maximum profit. If the position does not seem profitable, traders may choose to
extend the duration of the trade, and it can be done by closing the entire position and
opening it to some future expiry date. More time will increase the price of the options;
rollout may cost an additional amount and risk the overall position. The strike prices
of the options contract can be rolled up or down based on changes in the underlying
asset's price.
How to hedge a Call Backspread?
Hedging the call backspread may be unnecessary because the risk is very well defined
in this strategy. The strategy is bullish in nature which protects the stock from any
downward movement. The bear call spread has already defined the downside risk,
and any sharp decline in the stock price will lead to profit equivalent to credit received
while entering the strategy.
So, this was all about call backspread options strategy. We have seen how maintaining
the ratio between the long and short options contracts can help earn profit. You have
learned how to enter, exit, hedge, and roll out and the impact of time decay and
implied volatility on call backspread. If you have any further questions, you may
contact us using the number provided on the screen.