A call backspread is a strategy that involves selling lower strike price calls, represented by point A, and then buying a larger number of higher strike price calls, represented by point B. The lower strike price is usually an at the money option at the time of execution.
A trader who executes this position is bullish and is hoping for a larger upward movement in the stock, but has a conservative approach. If possible, the trader would want to execute a call backspread for a credit, that why they are starting out with the upper hand, and if the stock does trade down, they will still receive a small win.
The longer the expiration, the better the chance the investor has to win as the stock needs time to make that jump to that upper level. However, more time does mean a higher cost.
The closer the strike prices are together, the better for the investor, but that does come at a higher price. When the strikes are further apart, it is easier to establish this trade for a credit, but reduces the probability of the stock reaching the further out strike price.
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This trade has unlimited profit potential, once the stock moves past the upper strike and continues to trade higher profits continue to build.
This trade would reach its maximum loss when the stock pins at the upper long strike prices at expiration. This would mean the short calls would finish in the money and have value while the long calls would be out of the money and have no value.
The call backspread has two breakeven points and can be calculated as follows:
Lower breakeven = strike price of the short call
Upper breakeven = strike price of long calls + point of maximum loss
If a trader executed a backspread by selling a 50-strike price call for $3 and then buying two 55-strike price calls for $1.50, the trader would be able to put this trade on for a zero out of pocket cost.
If the stock stays below $50 at expiration, the trader will breakeven as both options would expire worthless.
If the stock trades to $55, the lower strike price call would be $5 in the money, while the 55-strike price calls finished out of the money. Here the investor loses a full $5.
If the stock traded to $70, the trader would lose $20 on the 50-strike price call and profit $15 on both of the 55-strike price calls($30), for a total profit of $10 ($30-$20).
This is a good strategy when there is the possibility of really good news coming out for a company that could push the stock to new levels. This might include a lawsuit being settled or a new high valued service.