The trader who executes this position is bullish and expects the stock to move higher but is taking a cautious approach.
A call backspread is a tactic that entails first selling calls with lower strike prices (point A), and then buying more calls with higher strike prices (point B). Typically, the option with the lower strike price is one that is executed in the money.
The trader who executes this position is bullish and expects the stock to move higher but is taking a cautious approach. The trader is starting out with the advantage because, if at all possible, they would like to execute a call backspread for a credit; even if the stock trades lower, they will still make a small profit.
Given that the stock needs time to rise to the higher level, the longer the expiration, the better the investor’s chances of winning. But more time does come at a price.
The investor will benefit more from close proximity between the strike prices, though at a higher cost. It is simpler to set up this trade for a credit when the strike prices are further apart, but there is a lower chance that the stock will rise to the higher strike price.
Profit/Loss
This trade has an unlimited potential for profit because as long as the stock trades higher after passing the upper strike, profits will keep increasing.
When the stock stalls at the higher long strike prices at expiration, this trade will lose the most money possible. This would imply that while the long calls would be out of the money and worthless, the short calls would finish in the money and have value.
Breakeven
There are two breakeven points for the call backspread, which can be calculated as follows:
Lower breakeven =Strike of the short call’s contract
Upper breakeven =plus the maximum loss plus the strike price of long calls
Example
A trader could enter this trade with no out-of-pocket expense if they used a backspread that involved selling a 50-strike price call for Rs3 and buying two 55-strike price calls for Rs1.50.
The trader will break even if the stock price remains below Rs50 at expiration because both options will expire worthless.
The lower strike price call would be Rs5 in the money if the stock reached Rs55, but the calls with a strike price of Rs55 would have lost money. The investor here loses the full Rs5.
The trader would lose Rs20 on the 50-strike price call and make Rs15 on each of the two 55-strike price calls (Rs30) if the stock traded to Rs70, for a total profit of Rs10 (Rs30-Rs20).
Conclusion
This is a wise course of action when there is a chance that a company will receive truly positive news that will raise its stock price. A lawsuit settlement or the launch of a new, highly regarded service are two examples.
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