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Backspread - Definition
Options Trading Strategies designed to profit from volatile market conditions.
Backspread - Introduction
What exactly are volatile markets? In Options Trading, volatile markets or volatile stocks refers to market conditions or stocks that are expected to move either up or down strongly. Such volatile conditions might be expected ahead of important news releases, court rulings, rate decisions and any conditions that might cause uncertainty as to the future direction of the market or stock. Backspreads or Volatile Options Strategies, allow options traders to take both bullish and bearish stance simultaneously in order to profit no matter which way the underlying stock moves, as long as it moves strongly enough to cross the breakeven line. Options traders utilizing backspreads are known as backspreaders.
Backspread - Betting on Volatility
Apart from being able to profit no matter if a stock breaks out to upside or downside, backspreads are also capable of profiting from volatility itself. This is also why backspreads are meant for volatile market conditions. Because most backspreads are inherently delta neutral, which means that they have an initial position delta value of zero or very close to zero, and a positive vega value, they are capable of increasing in value as long as implied volatilty increases without the stock even moving. In options trading, the higher the implied volatility, the higher options premiums become. Conversely, if implied volatility should fall instead, the backspread would lose money even if the stock does not move. This is why backspreads are commonly used many days before a breakout is expected to happen so as to ride the increase in implied volatility all the way to the day of the event.
Here is a list of popular backspreads:
Long Straddle - The grandfather of all backspreads and is certainly the most popular. It involves simply buying an ATM call and ATM put on the underlying stock.
Long Strangle - A variation of the Long Straddle using OTM calls and puts instead.
Long Gut - A variation of the Long Straddle using ITM calls and puts instead.
Short Bull Ratio Spread - Also known as a Call Ratio Backspread is another popular backspread strategy giving unlimited profit to upside and limited profit to downside through buying OTM calls and selling ITM calls.
Short Bear Ratio Spread - Also known as a Put Ratio Backspread is a variation of the Call Backspread using put options instead of call options, giving unlimited profit to downside and limited profit to upside.
Here is a list of more complex backspreads:
:: Short Butterfly Spread
:: Short Condor Spread
:: Reverse Iron Butterfly Spread
:: Reverse Iron Condor Spread
Advantages of Backspreads
The main advantage of backspreads is in trading increases in volatility, which is highly predictable, as well as to speculate on stock breakouts. Trading based on such multiple outlooks is the versatility that only options trading offers.
Drawbacks of Backspreads
Even though Backspreads offers the unique ability of profiting from both up and down moves, its nemesis comes in the form of stock remaining stagnant. As backspreads are typically put on ahead or during periods of high volatility resulting in high option premiums, potential losses should the underlying stock remain stagnant could be very significant. Even though stocks rarely stay stagnant over significant periods of time, Murphy's Law does apply and backspreaders need to be aware and cater for such potential losses. Fortunately, maximum potential losses can be precisely calculated for all backspreads. As such, you would be able to determine in advance if the potential reward justifies the risk involved.