Call Backspreads: Limited Risk, Huge Upside

by Lawrence Meyers | April 3, 2013 8:42 am

Call Backspreads: Limited Risk, Huge Upside

Contrary to what you might think, the call backspread is not some fancy swimming stroke — it’s a really neat way to speculate on a big upside move in a stock while presenting very little risk. Thus, it’s really great for those momentum stocks we all know and love.

Here are the details for this options trade:

You’ll be selling a call at a lower strike and buying a greater number of calls at a higher strike price. It’s best to use in-the-money options because they have a higher likelihood of ending up in-the-money.

If you choose the right stock and strike prices, you shouldn’t end up with too much of a debit in the process and might even clear a credit. If the anticipated event should happen to move the stock down, you won’t lose much. However, if you correctly anticipate that large move upward, you have unlimited profit potential. Even better, you should have more calls on the upside than the downside.

Here’s how the math works, as far as figuring out where you break even on the upside:

Breakeven = Long strike price + [(strike price difference) x # of short contracts] – [net debit/100]. Note that the net debit might be a net credit, depending on the circumstance.

But let’s get real and make sure we aren’t going to get killed if the trade goes against us. Maximum Loss = (Strike price difference) +/- Net debit/credit.

Let’s grab two real-world examples. So that means picking something like Chipotle Mexican Grill (NYSE:CMG[1]), which reports earnings on April 18, with expiration being the very next day. As of this writing, Chipotle trades at $323.

Example 1

Let’s sell the April 310 Call for $19, and then we’ll buy 2 April 325 Calls for $9.60 for a total expense of $19.20. That gives us a net debit of only 20 cents.

If the stock finishes at $310 or below, you will not be forced to buy Chipotle shares at $310 and have them called away since nobody will buy a $310 stock selling for less.

If the stock goes above $340, you will make out like a bandit, collecting $200 for every point the stock moves above that strike price. You’ll see a loss, however, if Chipotle is between $310 and $325. You’ll be forced to buy the stock at $310 and sell it to the call buyer at the price on expiration day. Anything above $325, however, and you will enjoy gains on the calls you purchased to offset the forced sale of the stock.

Example 2

The same situation, except you sell the April 320 Call for $13, and then we’ll buy 2 April 325 Calls for $9.60, for a total expense of $19.20. That gives us a net debit of $6.20.

In this case, you are risking $620 up front, but by tightening the strike price spread, your maximum loss will be reduced.

As of this writing, Lawrence Meyers[2] did not hold a position in any of the aforementioned securities. He is president of PDL Capital, Inc.[3], which brokers financing, strategic investments and distressed asset purchases between private equity firms and businesses. He also has written two books[4] and blogs about public policy, journalistic integrity, popular culture, and world affairs[5]. Contact him at pdlcapital66@gmail.com[6] and follow his tweets @ichabodscranium.

Endnotes:
  1. CMG: http://studio-5.financialcontent.com/investplace/quote?Symbol=CMG
  2. Lawrence Meyers: mailto:pdlcapital66@gmail.com
  3. PDL Capital, Inc.: http://www.pdlcapital.com/
  4. written two books: http://www.investorplace.com/author/lawrence-meyers/
  5. blogs about public policy, journalistic integrity, popular culture, and world affairs: http://www.breitbart.com
  6. pdlcapital66@gmail.com: mailto:pdlcapital66@gmail.com

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