by The TradeWins Publishing Editors

The option “backspread” can be an excellent strategy under the right market conditions. In the language of options, a multiple option strategy in which you are long more options than short is called a backspread. It may also be called a “ratio backspread” since there is a ratio of long to short options (often 1-to-2, or 1-to-3).

This strategy might be used when:

  1. The trader sees the potential for a significant move in a certain direction, but doesn’t want to lose money if the market moves in the opposite direction.
  1. Implied Volatility in the out-of-the-money options is very low, but the trader expects volatility to rise sharply when the move begins.

When option implied volatility reaches very low levels, it may be during a quiet market or at price extremes, conditions which can sometimes lead to another major move. The backspread is a trade that can often be initiated with no initial premium cost, has little or no risk if the market moves against you, has a defined loss limit, and has unlimited profit potential. If initiated at a premium credit, the backspread can even make profits if the market moves opposite the expected direction. Besides the profit potential from a directional move in the underlying futures, the backspread can benefit from an expected increase in option implied volatility that often accompanies a large market move. Since these trades are often initiated when option implied volatility is low, a rise in option i.y. can significantly add to profit potential.

The ratio backspread is the opposite of the “ratio spread”, in which the trader is short more options than long. The time to consider using the ratio spread is typically after a market has already made a large move and option implied volatility is very high, the opposite of the ideal conditions for using the backspread.

For call options, a typical “call ratio backspread” involves buying two or three call options, and selling one call option with a lower strike (closer to the money, or deeper in the money). Often the trade is initiated at about even money, or even at a credit.

The best market conditions for initiating the option backspread:

  • Low option implied volatility. This condition can often precede a large market move, which will then normally lead to an increase in option i.v.
  • The expectation for a large move in the market.
  • A market where option implied volatility is likely to increase if a trend develops in the expected direction. In some markets, this is an important consideration, because option i.v. will normally only rise in one market direction. For example, in the grains, rallies usually generate a rise in option volatility (more public speculation), whereas in the S&P stock index, big declines cause option i.v. to rise (panic buying of put options for portfolio protection). In other markets, option i.v. may increase during large moves in either direction, simply from more speculative interest.
  • A market where premium disparity occurs (out-of-the-money options have greater implied volatility, and greater increase in i.v. during a big move). Normally, these markets exhibit some form of “option skewing” during normal market conditions. This means that either option volatility increases from low strikes to high strikes (positive skewing, typical in grains), it increases from high strikes to low strikes (negative skew, typical in stock indexes and meats), or rises in both out-of-the-money options in both puts and calls, with the lowest option i.v. at the money.
  • Initiate trades with at least 3 months to option expiration, preferably as long as 6-9 months. The more time until option expiration, the more time there will be for a market move to occur. When using options in distant months, be sure to use option strikes that have the best trading volume and open interest, to facilitate trade entry.

*This time parameter is also important because the intended holding period for a backspread may only be about half the time until option expiration. In other words, if things don’t start to move favorably at about half-way to expiration, it may be best to close the trade or roll out to a new position, as the risk/reward scenario can start to deteriorate in the last few weeks before expiration.

Chart Example:

This chart shows profit/loss estimates for a call ratio backspread in Sugar, using a “one-by-three” strategy, long (3) 700 calls, short (1) 600 calls, with about 20 weeks until option expiration. Option implied volatility is near multi-year lows, and could be expected to rise if Sugar started a strong rally. The trade entry price would have been near even money, according to option settlement prices when the chart was created. In other words, the sale of the single 600 call would pay the premium cost of the three long 700 calls.

In this chart you can see that the trade has unlimited profit potential on a rally, with potential loss estimates very minimal during the first half of the time until expiration. This is why it may be prudent to close a backspread before expiration, if the trade isn’t moving in your favor. Also, remember that if a rally occurred, profit/loss estimates would be higher, due to the benefit from a probable rise in option implied volatility.