Option Investor
Educational Article

Backspreads And Ratio Spreads

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By Lee Lowell

As we continue our strategy session for this week, we're going to discuss two more spread positions that are comprised of unequal amounts of options. The "backspread" consists of more long options than short, and the "ratio spread" consists of more short options than long. Some of you may not be able to initiate the ratio spreads due to your broker's policies on naked short options, but we will talk about how to get around this little problem.

Let's first give the background on each strategy and see how to set them up. The backspread is an options spread strategy in which you buy more options than you sell and is executed within the same expiration month. This usually occurs in a 1x2 or a 2x3 ratio. Since you are long extra options, you want to see LARGE movement in the underlying stock or index. The backspread is NOT a strategy to use in a quiet market. The backspread can either be a call backspread or a put backspread, therefore you have to form an opinion on market direction. The backspread is also classified as a type of "volatility" spread, whereas you want to take advantage of the "skew" characteristics of each option. (If you recall, skew refers to the different implied volatilities of each option.)

There a few ways to decide on which strikes to use for a backspread. But even before you pick the strikes, just know that you should ALWAYS initiate a backspread for a credit into your account. This is the buffer you have in case your market prediction of direction does not pan out. Since you will be taking in a credit and using the skew to your advantage, you need to find options that present those qualities. In the case of a call backspread, you need to look for a "reverse" type of skew where the lower strikes trade at a higher implied volatility than the higher strikes. And in the case of initiating a put backspread, you want a "forward" skew in which the higher strikes trade at a higher implied volatility than the lower strikes. You want to see these characteristics because you are selling the more expensive strike (on dollar and IV terms) and buying the less expensive strikes (on dollar and IV terms). Most data vendors nowadays have implied volatility data included with their option chains.

We'll start with the put backspread. In this scenario, you are predicting large downside movement in the stock or index. But since we will execute this trade for a credit, we'll have the chance to keep some money if the stock goes screaming higher. Let's take some real numbers for Yahoo! and see what the scenario looks like.

(Illustrative purposes only!)

We think Yahoo's life as an Internet portal is about to end so we want to bet on a large downside move. You want to pick a month that will give it some time to mature, so we think October is a fair choice. The only other thing to be aware of with backspreads is that you'll want to exit the trade when there's at least 30 days left to its life. This is because if the underlying stock or index does not move in the given time, you will start to lose money quickly. Exiting with a month left still gives your long options some time value, so therefore you can sell out for hopefully not too big of a loss.

Which strikes to pick? In most backspreads, the option sold will be in-the-money and the options bought will be either at-the-money or slightly out-of-the-money. For our Yahoo! example, we will purchase 2 Oct '01 $20 puts at $4.10 and sell 1 Oct '01 $35 put at $15.20 for an overall initial $700 credit. This is with Yahoo! trading at $21/share. Here's the risk graph at 3 different time intervals:

This is the P&L graph on 5/1, the day we initiated the spread:

Halfway through on 8/01:

And here is the graph at expiration in October:

You can see how as time progresses we will lose money if Yahoo! does not make its intended move. What's nice about this put backspread is that if Yahoo! drops big, we will make unlimited up to Yahoo! dropping to $0/share or we can keep our initial $700 credit if Yahoo! powers higher above $36/share. From the graph at expiration we can see our break-even points are $11.88 on the downside and $28.13 on the upside. The position has the same structure as a straddle except that we're capped on an upmove by Yahoo!. What makes this better than a straddle in one respect is that we get to take in an initial premium whereas with a straddle, you have to shell out money from your account. There is a chance of loss with a backspread as can be seen by the graph, but the only reason why you would initiate a backspread is because you expect large movement. If the large movement occurs, you're golden.

Just in case you were wondering about the volatility skew in this example - the Yahoo! options had a relatively flat skew. This means that the options we bought and sold were trading at very similar IV. The $20 put was purchased at about 90% IV and the $35 put was sold at about 88% IV. That's not our ideal, but I used this example just to illustrate how the spread works. If the skews had been more favorable, we would've ended up with a larger initial credit. Having a simple software program where you can see the actual strategies with P&L graphs really helps you see where the money will come and go. Even if you know in your head what your breakeven points are and what the max loss and max gain may be, it's still nice to see it on a graph.

We used a put backspread in this example but a call backspread is used in the same manner. If you are bullish on the market, sometimes a call backspread is preferable to an outright call purchase due to the favorable (hopefully) skew pattern, and the chance to make money if you are totally wrong on your market prediction.

I've run out of time for this week, so I will get to the ratio spreads in the next session.

Good luck.


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