Also known as Ratio Volatility Spread or a Pay Later Call, the back spread with calls is an unusual strategy. Essentially, you’re selling an at-the-money short call spread in order to help pay for the extra out-of-the-money long call at strike B.
Establish this strategy for a small net credit whenever possible. That way, if you’re dead wrong and the stock makes a bearish move, you can still make a small profit. However, it may be necessary to establish it for a small net debit, depending on market conditions, days to expiration and the distance between strikes A and B.
When to Run It
Ideally, run this strategy using longer-term options to give the stock more time to move. However, the marketplace will react. The further you go out in time, the more likely it is that you will have to establish the strategy for a debit.
In addition, the further the strikes are apart, the easier it will be to establish the strategy for a credit. But as always, there’s a trade-off. Increasing the distance between strike prices also increases your risk, because the stock will have to make a bigger move to the upside to avoid a loss.
If the stock only makes a small move to the upside by expiration, you will suffer your maximum loss. However, this is only the risk profile at expiration.
After the strategy is established, if the stock moves to strike B in the short term, this trade may actually be profitable if implied volatility increases. But if it hangs around there too long, time decay will start to hurt the position. You generally need the stock to continue making a bullish move well past strike B before expiration in order for this trade to be profitable.
Maximum Potential Profit
There’s a theoretically unlimited profit potential if the stock goes to infinity. But since the real world doesn’t always operate like a theoretical one, let’s just say a lot.
Maximum Potential Loss
Risk is limited to strike B minus strike A, minus the net credit received or plus the net debit paid.
Break-even at Expiration
If established for a net debit, the break-even point is equal to strike B plus the maximum risk (strike B minus strike A plus the net debit paid).
If established for a net credit, there are two break-even points for this play:
- Strike A plus the net credit received
- Strike B plus the maximum risk (strike B minus strike A minus the net credit received)
Ally Invest Margin Requirements
Margin requirement is the difference between the strike prices of the short call spread embedded into this strategy.
NOTE: If established for a net credit, the proceeds may be applied to the initial margin requirement. Keep in mind this requirement is on a per-unit basis. So don’t forget to multiply by the total number of units when you’re doing the math.
The net effect of time decay depends on where the stock is relative to the strike prices and whether or not you’ve established the strategy for a net credit or debit.
If the strategy was established for a net credit:
- Time decay is your enemy if the stock is at or above strike A, because it will erode the value of your two long calls more than the value of the short call. Time decay will do the most damage if the stock is at or around strike B, because that’s where your maximum loss will occur at expiration.
- If the stock is below strike A, time decay is your friend. You want all of the options to expire worthless so you can capture the small credit received.
If the strategy was established for a net debit:
- Time decay is the enemy at stock prices across the board because it will erode the value of your two long calls more than the value of the short one.
After the strategy is established, an increase in implied volatility is almost always good. Although it will increase the value of the option you sold (bad), it will also increase the value of the two options you bought (good). Furthermore, an increase in implied volatility suggests the possibility of a wide price swing.
There’s an exception to this rule if you established the strategy for a net credit and the stock price is below strike A. In that case, you may want volatility to decrease so the entire spread expires worthless and you get to keep the small credit.
This is a trade you might want to consider just before a major news event. For example, an announcement regarding the Food and Drug Administration’s approval of a miracle drug on a pharmaceutical stock, the outcome of a major legal case or a pending patent approval.