Back spreads and ratio spreads are usually discussed together because they are simply the mirror image of each other. Back spreads and ratio spreads are comprised of either both calls or both puts at two different strike prices in the same expiration month. If the spread has more long contracts than short contracts, it is a Back Spread. If there are more short contracts, it is a Ratio Spread.
Since ratio spreads involve selling “naked” (i.e., uncovered by another long option) they can’t be used in an IRA. For that reason, and because we like to sleep better at night knowing that we are not naked short and could possibly lose more than our original investment, we do not trade ratio spreads at Terry’s Tips.
Back spreads involve selling one option and buying a greater quantity of an option with a more out-of-the-money strike. The options are either both calls or both puts.
A typical back spread using calls might consist of buying 10 at-the-money calls and selling 5 in-the-money calls at a strike low enough to buy the entire back spread at a credit.
Ideally, you collect a credit when you set up a back spread. Since the option you are buying is less expensive than the one you are buying, it is always possible to set up the back spread at a credit. You would like as many extra long positions as possible to maximize your gains if the underlying makes a big move in the direction you are betting.
If you are wrong and the underlying moves in the opposite direction that you originally hoped, if you had set up the back spread at a net credit at the beginning, all of your options will expire worthless and you will be able to keep the original credit as pure profit (after paying commissions on the original trades, of course).
Call back spreads work best when the stock price makes a large move up; put back spreads work best when the stock price makes a large move down.
One of the easiest ways to think about a back spread is as a vertical with some extra long options. A call back spread is a bear vertical (typically a short call vertical) plus extra long call options at the higher of the two strikes. A put back spread is a bull vertical (typically a short put vertical) plus extra long put options at the lower of the two strikes.
The purpose of a back spread is to profit on a quick extended move toward, through and beyond the long strike. The purchase of a quantity of more long options is financed by the sale of fewer short options. The danger is that because the short options are usually in the money, they might grow faster than the long out-of-the-money options if the stock price moves more slowly or with less magnitude than expected. This happens even faster as expiration approaches. The long out-of-the-money options may lose value despite a favorable move in the stock price, and that same move in the stock price may increase the value of the short options. This is when the back spread loses value most quickly. This is depicted in the “valley” of the risk profile graphs. The greatest loss in the graph occurs at exactly the strike price of the long options.
There are two reasons that I personally don’t like back spreads. First, they are negative theta. That means you lose money on your positions every day that nothing much happens to the underlying strike price.
Second, and more importantly, the gains you make in the good time periods are inconsequential compared to the large losses you could incur in the other time periods. If the stock moves in the opposite way you are hoping, you end up making a very small gain (the initial credit you collected when the positions were originally placed). If the underlying doesn’t move much, your losses could be huge. On the other hand, in order for you to make large gains when the market moves in the direction you hope it will, the move must be very large before significant gains come about.
Here is the risk profile graph for a back spread on SPY (buying 10 Dec-12 142 calls for $1.55 and selling 6 Dec-12 140 calls for $2.78 when SPY was trading at $142.20 and there were two weeks until expiration):
You have about $1100 at risk (the $1200 maintenance requirement less the $115 credit (after commissions) you collected at the outset. If the stock falls by more than $2.20 so that all the calls expire worthless, you would gain the $115 credit. If the stock moves higher by $2, you would lose just about that same amount. It would have to move $2.20 higher before a gain could be expected on the upside, and every dollar the stock moved higher from there would result in a $400 gain (the number of extra calls you own).
The big problem is that if the stock doesn’t do much of anything, you stand to lose about $1000, a far greater loss than most of the scenarios when a gain could be expected. In order for you to make $1000 with these positions, the stock would have to go up by $5 in the two-week period. Of course, that happens once in a great while, but probably less than 10% of the time. There there is a much greater likelihood of its moving less than $2 in either direction (and a loss would occur at any point within that range).
Bottom line, back spreads might be considered if you have a strong feeling that the underlying stock might move strongly in one direction or another, but I believe that there are other more promising directional strategies such as vertical spreads, calendar or diagonal spreads, or even straddles or strangles that make more sense to me.