A backspread, also reverse ratio spread, is a strategy used to trade when stocks are volatile. A trader can use backspreads when stocks are volatile, but without clear signal of where the volatility might swing. This is comparable to hedging in forex trading where one performs sell and buy trades simultaneously, and close the losing position while holding the winning when the currency breaks towards one direction. Unlike hedging that lasts a while, backspread profits are unlimited.
In stock options, there are backspreads and put backspreads. When you “put”, you are placing a target price lower than the current stock price anticipating the price will drop to and past your defined price or strike target. When you “call”, you place your strike target above the current stock price expecting the stock price will rise to and past that level. When carefully planned, backspreads can be profitable for a long time.
Call Backspread (reverse call ratio spread)
When a trader trusts the market might go up (bullish), but is not sure about it, he can buy (call) the stock and backspread it. This is by buying or calling some OTM stock options and selling a lesser ITM number of the same stock. OTM (Out-of-The-Money) is strike or target price higher than current stock price. ITM (In-The-Money) is the inverse of OTM meaning, the strike price should be lower than current stock price. So, if the call backspread ratio is 3:1, one will sell 1 ITM for every 3 OTM bought.
Put Backspread (reverse put ratio spread)
This works the same as a call backspread but a trader is optimistic the stock will get weak (bearish) soon. The trader puts or buys some of the stock at a strike price below current stock price (OTM) and sells a smaller amount with a strike price above current stock price (ITM).
Advantages of backspreads
It’s clear that, when the price moves towards the favored direction past the OTM strike price, the trader will profit as long as that position runs. Should the price move below the ITM strike price or move upwards, but does not hit the OTM strike price, it will be a loss. However, the advantage with backspreads is that, if the trader buys back the option before expiry, he will earn the premium made by opening the call backspread (credit position).
Understanding credit position
The margin requirements for backspreads are moderately low meaning one can open a backspread using credit only. This enables the trader to profit despite the direction of the market. However, the credit profit is limited to credit received when the backspread was opened.
Risk of backspreads
Backspreads are profitable in volatile stocks, and not lagging or stagnant ones. Since one cannot let a backspread position expire, using them in stocks that are not volatile will result to losses after buying back the options.
Most backspreads are only short-term. If a trader wants to use them for long-term trading, he can use diagonal backspreads that are fit for volatile high premium markets.
Option Volatility & Pricing: Advanced Trading Strategies and Techniques by Sheldon Natenberg