What is a backspread?
A backspread is a way some people try to make money in the stock market. It’s a type of options strategy. Options give you the choice to buy or sell stocks later at a set price.
With a backspread, you sell a small number of options that will make money if the stock goes up or down just a little bit. At the same time, you buy a bigger number of options that pay off if the stock shoots way up or crashes way down.
So you’re betting the stock price will move a lot, but you’re not sure which direction. You want the stock to be jumpy. The fancy word for this is volatility. If the stock stays calm, you’ll lose a little money. But if it goes wild, you can win big.
Long call backspread
One kind of backspread is called a long call backspread. With this, you sell call options at a strike price closer to where the stock is now. And you buy more call options at a higher strike price.
If the stock soars past both strike prices, the calls you bought will be worth a ton more than the ones you sold. You’ll make out like a bandit.
Long put backspread
The other kind is a long put backspread. Here you sell put options at a strike price closer to the current stock price. And you buy more puts at a lower strike price.
If the stock tanks below both strike prices, your bought puts will pay off way more than your sold puts lose. You can clean up.
How do backspreads work?
Most people buy stocks hoping they’ll go up. If the stock rises, they make money. If it falls, they lose. Pretty simple.
Options let you make money from big swings either way. They’re like side bets on how much the stock will move.
Calls vs puts
A call option bets the stock will go up. It’s the right to buy the stock later at a set price. That locked-in price is called the strike price. A put option bets the stock will go down. It’s the right to sell the stock later at the strike price.
Options have expiration dates. That’s the deadline to use them or lose them. Options that expire soon are cheaper since there’s less time for the stock to move. Options that expire later cost more. They have more time value.
Backspread basics
With a backspread, you’re selling some cheap options to help pay for the more expensive ones you’re buying. You sell options at one strike price and buy more of them at a different strike price.
The options you sell will lose a little if the stock jumps in the direction you guessed. But the ones you bought will gain a lot more. You want the stock to make a big move so your gains on the bought options outweigh your losses on the sold options.
When to use a backspread
Backspreads are for when you think the market will get volatile but you’re not sure which way it’s going. You want to profit off surprise moves without having to predict if stocks are headed up or down.
Before earnings
For example, let’s say a company has an earnings report coming up. You think the news will shock Wall Street and send the stock flying one way or the other. But you don’t know if it will be good or bad. A backspread lets you make money either way.
Cheap protection
Backspreads can also be a cheap way to protect your portfolio. You’re not paying much for the chance to make a lot if there’s a big sell-off. It’s like buying a really good insurance policy on the cheap.
But like any insurance, you’re out the premium if nothing bad happens. With a backspread, you’ll lose the difference between what you paid for the options and what you got for selling the other ones if stocks stay steady. It’s the price of protection.
Risks of backspreads
Backspreads are not a magic money machine. They only work if the market moves enough to make your bought options profitable. If stocks just drift, your sold options will lose more than your bought options make.
Capped profits, high breakevens
The options you sell put a cap on how much you can make. After a certain point, the ones you bought can’t gain any more than the ones you sold lose. And to get to that profit peak, the stock has to move a whole lot. The breakeven points on backspreads tend to be very wide.
Early assignment
Backspreads also come with a special risk called early assignment. That’s when the options you sold get exercised before expiration. It can happen if the stock moves in-the-money past your short strike.
When you’re assigned, you have to either sell stock you own or buy it at the strike price. That can leave you with an unintended pile of shares. If you’re not ready to pony up the cash, it can cause real problems.
Real-world example
Here’s how a real backspread trade might look. Let’s say XYZ stock is at $100. You think it’s going to be a wild ride but you’re not sure which direction.
You sell 10 XYZ $105 call options expiring next month for $1 each. That brings in $1,000. At the same time, you buy 20 XYZ $110 calls with the same expiration for $0.50 each. That costs you $1,000. Your net outlay is zero.
If XYZ stays between $100 and $105 until expiration, all the options will expire worthless. You won’t make anything but you won’t lose either.
If XYZ rockets above $115 though, you’ll make some serious cash. The 20 calls you bought for $0.50 will be worth at least $5 each. That’s a gain of $9,000. The 10 calls you sold for $1 will lose $1,000. So you’ll net $8,000 in profits.
The same kind of thing can happen with puts if the stock crashes. The more XYZ moves, the more you can make. But it has to really jump to overcome your initial sale of the cheaper options.
