We recently discussed ratio spreads, so I thought we would discuss the flip-side of this trade, the "backspread."
Where the ratio spread involves buying a set number of contracts and selling more of the same type of option further out of the money within the same expiration month, the backspread buys more options than it sells. They are really two sides of the same trade: It is a ratio when you sell it and a backspread when you buy it.
Earlier this month, for example, we saw one trade that involved 34,000 of the E*Trade April 2 calls and 68,000 of the April 3 calls. They both traded for $0.20. So this could have been a ratio spread, with the trader buying the 34,000 of the April 2 calls and selling the 68,000 of the April 3s. This trade would not lose anything with ETFC below $2, would take its greatest gain at $3, and then have significant potential losses starting around $3.
But if the trade was a backspread, the 2s would have been sold and the 3s bought. The trade still have no risk below $2. But in this case the greatest loss would be taken with the stock at $3 at expiration. But a move above $4, or a quick move higher with higher implied volatility, should create gains for the backspread.
We can see the following backspread in the SPY exchange traded fund, the ETF for the S&P 500. This backspread sells the September 98 call while buying two of the September 101 calls and is done for a credit--in this case, $0.19.
I always like to do my backspreads for a credit so that, regardless of how low the SPY goes, you get a profit. If the SPY jumps from current levels, your profits should travel up the orange line in the profit-and-loss diagram above. But time decay will create losses, with the maximum at 101 at expiration. (See optionMONSTER's Education section).
Backspreads then are a hedged trade, and provide an excellent way to trade a specific outlook. Both calls and puts can be used with backspreads, but it is good to pay attention to the volatility "smile" or "smirk." Because you are buying the further out of the money options, and more of them, then this strategy is best if those options have even or lower implied volatility.
Disclosure: E*Trade is a competitor of optionMONSTER's sister company, tradeMONSTER.