Bull Call Backspread
A bull call backspread is similar to a long call option as far as your outlook on the underlying stock (i.e. you want it to go higher), but you use the sale and purchase of different ratios of options to protect against a possible move lower. These are often referred to as “ratio spreads” because you are buying and selling options at intervals of 1:2 or 2:3 etc. With this particular strategy, you would sell a call option and then buy 2 higher strike calls, which still makes you a net buyer of options at a ratio of 1:2.
In this video, we’re going to talk about a bullish strategy, the bull call backspread. I know it’s a big mouthful there, but it's a great strategy and an easy way to take a long position in a stock without taking the extra risk of a general long option.
Let’s get right into it here as always. The market outlook for the call backspread here is that you are going to want to see a bullish move in the underlying stock. Typically, you want to see a pretty significant upside move.
What you want to do with this is you also want to keep your downside risk limited. This is going to be a more limited downside risk as opposed to just a regular call option. A regular call option would have (at the lower strike here or, the higher strike at 45) downside risk capped at this point going out so at $500.
But with the call backspread, what you’re going to do is just make that one point the maximum loss point and everything beyond there, you actually might end up not making any money, but at least you won’t lose any money. That's the whole idea with the bull call backspread.
How do you set this up? It’s a little bit more complex than your average run-of-the-mill strategy, but all you’re going to do is basically sell a number of calls with a lower strike and buy twice that number of calls at the higher strike.
In our example, we’re going to sell one in the money 40 strike call and we’re going to buy two out of the money 45 strike calls. You just want to sell twice as many. If you want to do the spread as selling two and buying four or selling 10 and buying 20, you can do that. As long as you have that 1:2 ratio, you should be in good shape as far as building this strategy.
What’s the risk of the strategy? The maximum loss would occur should the stock close right at the upper strike price. If the stock closed right at 45, that would create the maximum loss of $500 in this case.
The reason that creates that loss is because we are long two options at $45, so those options would expire worthless and then make no money and then we'd be also short a 40 strike which would be $500 in the money, so we’d have to buy that option back and that’s where the $500 loss comes into play as far as our maximum area.
Anything around 45 and it would be a differing loss all coming back towards the zero barrier if we get beyond 40 and beyond 50. This is actually a pretty good strategy for a market that is pretty volatile, highly volatile in either direction.
It just has more of a bullish tilt to the strategy than generally speaking. But it’s not a good strategy for sideways or neutral markets and really, it’s flat out horrible for those types of markets.
The profit potential for this strategy is technically unlimited to the topside. The stock has no theoretical cap. It can go up forever. But you can also build a strategy, so that it makes money by the stock falling and taking in a credit when the position opens.
We’ll go over this here at the end of the video, but as you can see on my profit loss chart, I’ve built this strategy for the purposes of this example to make no money at all right at the zero barrier should the stock close anywhere below 40.
But if you build the strategy to where you take in a small credit here, you can actually build this strategy to take in a small credit, maybe $50 or $25, something that pays you back for your commissions already and then it becomes more of a market neutral strategy.
Let’s talk about volatility here. Increases in implied volatility all other things being equal is going to have a very positive impact on this strategy. Remember that when we were building this strategy, we were short one option at 40 and we were long two options at 45.
We were short one at 40 and long two at 45. Remember that this extra long call option here is going to have all of the Vega or volatility features of the strategy. The other two options are going to more or less cancel themselves out.
But since we’re long an extra call option, it’s going to act more like a long option. And since volatility is great for the strategy, big wild swings are great, that's what creates this profit zone up here, we want the stock to move violently and move into a profit zone once we enter the trade.
Time decay is actually going to have a negative impact on this strategy. Since we are net long calls, the Theta overall is going to hurt our position. Since we have that extra long call at 45, then time decay is going to be working against us.
We need the strategy or the underlying stock to move into a profit zone. If it doesn't move, then every single day, the option values are going to decay and we’re going to move more and more towards our maximum loss feature.
Just like volatility, the more out of the money the calls are, the smaller the time decay effects are going to be. The more out of the money you have call options that are long, the smaller the effects of time decay overall.
Breakeven points are a little bit more complex to calculate, but we’re going to go over both of them here. You can see we have two breakeven points since this strategy crosses the profit-loss line twice.
The upper point is going to be the strike price of the long calls plus the maximum loss that you can incur. In this case, the strike price is 45, the maximum loss we can incur is 500, so we’re going to add that to 45, $5 per option and that gives us that $50 strike right here.
That’s the point at which we need the stock to move for us to start to make money at expiration. If the stock is trading at 45 when we entered this, we need it to move at least $5 just to break even.
The lower point or the lower breakeven point is going to be the strike price of the short call. You can see we sold a call at 40. If the stock moves down to 40, then we will actually make no money on this trade, but we also won’t lose any money as well.
Let’s look at a quick example. Let’s say the stock price is trading at 45. We’re going to sell one 40 call option for $400. We’re going to sell this 40 strike for $400. We’re going to go out in the market and buy two 45 calls for $200 apiece.
Notice that the sale of the 40 strike call is going to completely fund and provide the money for these two 45 strike calls at $200 apiece. This creates no debit or credit on this trade. The maximum loss here is $500. That's the strike minus the credit.
If the stock closes right at 45, our two long 45 calls that we paid $200 each for are going to expire worthless and our short call option at 40 is going to be $500 in the money. We’re going to have to buy that back to close out the trade which creates that $500 maximum loss.
The maximum profit to the upside is unlimited. If the stock just continues to move higher, that's great. That’s what we want with this strategy and that creates that unlimited feature.
You can create a little bit of profit down here by making sure that the sale of the one option is more than it cost to buy the other two options at 45. For example: If the sale of the 40 brought in $450 and it only cost you $200 each for the two long calls, you’d still be left with a credit of $50, in which case, anything below 40 would make you a profit of $50 to the downside.
And that's much more of a market neutral strategy. And really, what I like to create when I trade this is I like to create at least a little credit to the downside, so that if the market does really flop over and go against what I think is going to happen, then at least I’m bringing in some income on the strategy overall.
Some tips and tricks over the years: This strategy is a bear call spread and a long extra call. Think of it like a bear credit spread where you have a short option and a long option here and then we’re just adding that extra long call to the strategy which creates this new back spread strategy.
High volatility stocks where you can get into the trade with no money are best. This trade cost us no money to get into. Think about your account size. And if you want to create a strategy that has upside profit potential and it doesn't cost you anything to get into, this is a great one to trade if it’s in a high volatility stock.
It is possible to structure the strategy to make money if the stock falls. Just make sure that you sell the short call for more than you purchase the two long calls for. That creates a little bit of a credit and helps with your overall position and creates much more of a neutral strategy going forward.
Thanks again for watching this video and I hope you guys enjoyed it. As always, you can use the social media links right below this video to share the video with any of your friends, family or colleagues on your favorite social network.
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