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A back spread is essentially an inverted ratio spread When constructing a back spread, you are selling an option closer to the underlying market or even an in-the-money option while purchasing an
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out-of-the-money option premium at a ratio to the short option The back spread is designed for a low implied volatility scenario with the expectation of increasing implied volatility over time Back spreads are not short-term trades They should be created as long term as possible and is even a potential for Long-term Equity Anticipation Security (LEAP) options As an example we can look to Alcoa, a manufacturer of aluminum products This is not a trade recommendation, but the situation has similarities to favorable conditions for using back spreads An economic downturn and falling aluminum prices cause a rapid decline in the stock price which is likely recoverable in a reasonable period Let s look at Alcoa (AA) in the chart in Figure 75 You can see the sharp drop in price in AA stock over the course of the weekly chart, so what we are looking for is a return to the long-term uptrend and a breakout of the channel to the upside
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Alcoa weekly chart Courtesy of CSM Futures Group
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To create the back spread, we will buy two out-of-the-money calls, and we will sell one at-the-money call Look at the option chain in Figure 76 For this example we are using a slightly larger lot size We consider selling 10 of the October AA 600 call options for a premium of 320 while simultaneously purchasing 20 of the October 900 call options at 160 The net premium on this option spread is zero plus the costs of trading As we mentioned earlier, ideally you want this purchase in low implied volatility or at least average volatility on the short call option over the long call options In this case Alcoa has fairly high implied volatility because of its rapid decline, but the premium scenario, chart, and implied volatility relationship make it eligible for a back spread The breakeven calculation for the back spread with zero premium means that any price above 900 at expiration will be pro table, while any price below 600 will result in no gain or loss Between 600 and 900 is where the loss potential occurs on this spread You are short the 600 call with no coverage until 900, so if the value of the 900 calls is no longer equal to the 600 call premium, you have a loss
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Alcoa option chain Powered by Option Vue 6
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At expiration the distance between the two strike prices of 300 is the maximum risk plus costs of trading If this was a debit spread, you would have to add the premium paid to the 300 maximum risk plus costs of trading If the spread was created for a credit, the premium amount would be deducted from the 300 plus costs of trading Now let s look at this trade on a model as shown in Figure 77 The model shows us graphically the loss potential of the trade at expiration, but the back spread is one few option spreads in which you are not trying to accomplish time value decay You can see in the intermediate timelines that, as time passes, the breakeven increases on the horizontal price line The more time decay there is from the purchased options, the more the AA price is required to gain value You can also see the maximum loss at expiration price of 900 where the 600 call is fully in the money by 300 and where the 900 calls would be at the money and worthless The advantage to the back spread is that it is a limited risk trade with an unlimited upside potential that gains delta very quickly as
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Profit/loss by change in AA common price $ 4,000 3,000 2,000 1,000 0 1,000 2,000 3,000 4,000 270
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