Derivatives

How to generate profit in call option even when the underlying falls

Venkatesh Bangaruswamy | Updated on February 20, 2021

You can set up a call backspread by shorting a lower strike call and going long on multiple contracts of a higher strike call of the same maturity on the same underlying

Previously in this column, we discussed bull-call spread and bull-ratio spread. Is there a spread that generates profits when the underlying moves up and yet result in small profit if the underlying collapses? This week, we discuss one such spread — the call backspread — and its associated risks.

Aggressively bullish set-up

You can set up a call backspread by shorting a lower strike call and going long on multiple contracts of a higher strike call of the same maturity on the same underlying. This position can be set up either as a delta-neutral spread or with positive deltas.

Consider the delta-neutral spread. The positive deltas from the long position more or less cancel out the negative delta from the short position; delta is the change in the option price for a one-point in implied volatility. With a delta-neutral spread, you are betting on the implied volatility exploding (increasing). That is, you are betting that the underlying will move up to generate profits on your position.

Suppose you short the at-the-money call (ATM), you may have to short a deep out-the-money (OTM) call for a delta-neutral spread. So, the spread can be set up for a net credit. That is, the premium you collect on your short call will be higher than the premium you pay on your long positions. Assume you short 15,300 call with a delta of 0.53 and buy two contracts of 15,600 call that has a delta of 0.26. The spread is near-delta-neutral with a net credit of 70 points.

There is, however, high risk associated with this strategy. The maximum loss in a backspread occurs when the underlying trades at the long call strike at option expiration. The maximum loss would be the difference between the strikes minus the net credit, 230 points for the above example.

The spread will generate profits if the underlying trades above the upper breakeven, which is the long call strike plus the maximum loss. In this case, that is 15,830. Suppose the underlying trades at 16,000 at option expiration, the position will generate 170 points of profits. Note the requirement for a significant move in the upside for the backspread to be profitable.

You can also set up the spread with positive delta. That is, your long positions can have higher deltas compared to the short position. Suppose you short 15,300 call and buy two contracts of 15,400 call for a net debit spread of 78 points. Your maximum loss will occur when the underlying trades at 15,400 at option expiration, 178 points in this case- the difference between the strikes plus the net debit. The spread will generate profits if the underlying trades above the upper break-even of 15578 (15400 plus 178).

Optional reading

The call backspread benefits from increase in implied volatility. Because implied volatility is one of the two components of the time value of an option, this means that the spread will suffer losses when the underlying moves slowly; for then, even the spread set-up with positive delta can turn into negative delta.

How does call backspread compare with bull-call spread? Suppose you buy the 15,300 strike and short the 15,400 strike for a net debit of 55 points.

The maximum profit will be only 45 points, the difference between the strike minus the net debit, even if the underlying trades at 15,800 at option expiration. On the other hand, a 1:2 ratio of 15,300/15,400 backspread will result in a profit of 222 points, given the upper breakeven of 15,578.

The flip side is that losses are higher (178 points) compared to a bull-call spread (55 points).

That is why it is optimal to set up a backspread when the long strike is not far away from the short strike and yet the spread can be set up for near-zero cost or for a small net credit.

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Published on February 20, 2021

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