While the market is unlikely to shrug off the immediate concerns that have punished stocks in recent weeks, the past two days showed how the potent combination of an oversold condition and some good news can produce a pop in price.
After nearly six consecutive weeks of declines, many stocks are at 52-week lows and deeply oversold. They're coiled with the potential to rebound substantially higher in coming months.
Back spreads, which consist of being long more options than you are short in the same underlying stock using the same expiration date, offer a low-cost or no-cost way to establish leveraged positions that benefit from a large directional move in a relatively short time frame. A back spread typically starts off as a delta-neutral position, but because of the higher ratio of long options, the gamma and delta increase as price moves in the predicted direction.
An example of an even-money back spread would be selling one XYZ Corp. $30 call for $3 and buying three XYZ Corp. $35 calls for $1 per contract. This position has break-even points of $37.50 or any price below $30 at expiration. The profit potential is unlimited and the maximum loss is $5, or equal to the spread between strike prices minus the net cost of the position.
One of the keys to the successful construction of a back spread is identifying an option chain that allows the sale of one at-the-money option to finance the purchase of a multiple number of out-of-the-money options. The higher the ratio the better. But no matter how high the ratio is, turning a profit still mainly depends on the underlying stock moving enough to push the long options sufficiently into the money to offset the loss incurred in the option sold short. Theoretically, a huge increase in implied volatility with little or no price movement could in itself create a profit in a position.
Given the same strike prices, the ratio for an even-money back spread has an inverse relation to the expiration period. Simply stated, the option sold short will finance the purchase of a declining number of out-of-the-money options as the expiration period increases. The challenge in constructing a back spread with an attractive profit/loss profile is determining the minimum ratio required to deliver a profit based on a given price move. The goal is to establish a position that has the smallest separation between strikes, provides the highest ratio for the least cost and offers the longest time period until expiration.
If You Can't Get Up, You'll Fall Back Down
Because back spreads are a bet that volatility will expand (net long contracts) and price will trend strongly, we want to buy options that are relatively cheap on stocks that have the potential for significant price movement. Here are the three simple criteria I used for screening for candidates:
- stocks with a beta above 1.2;
- share price that has declined by at least 25% so far this year;
- options with implied volatility trading 50% below the 52-week high or within 20% of its 30-day historic volatility.
In choosing candidates for a call back spread, it is important to identify companies you believe will either have a fairly dramatic turnaround in price or continue the descent. A flat or marginally higher stock price is the worst-case scenario.
Jumping Higher or Croaking?
looks like a good candidate for a back spread. The former highflier has been taken repeatedly to the woodshed for punishment over the last year after a string of disappointing results. At $17.50, the stock is down 31% for the year to date and some 60% below its 52-week high.
But even after receiving another, and what could be the last, round of analyst downgrades on Monday in the wake of
Toys R Us'
announcement that it will be exiting the toy business, LeapFrog managed to close higher on Tuesday, indicating the stock may have washed out. If third-quarter earnings (currently scheduled for release the first week of November) show it has reversed the trend of shrinking margins and expanding inventories, the stock should at least make a run to fill the gap at $26 per share. If the company disappoints again, expect the stock to sink to new lows.
Let's look at a possible example of how a back spread might be established and play out. On Tuesday, with LeapFrog trading at $17.50 per share, the January $15 call could be sold for $3.75 and the January $25 calls can be purchased for $1.25 per contract, meaning the back spread can be established on a 3-to-1 ratio for even money. The table below illustrates the cost, break-even points and potential profit.
Trading in the Gains
The table above shows values at expiration; it's important to note that by using a longer-dated back spread, profit can be realized at lower price levels.
Assuming implied volatility remained at the current 44%, if LeapFrog shares were trading at $22.50 on Nov. 17, the January $15 call would have theoretical value of $7.65 and the January calls with the $20 strike would be worth $3.25 each. That would give the position a net credit or profit of $2.10 per 1-by-3 unit spread. If LeapFrog hit the $22.50 level on Oct. 15, the spread will have a value of $3.25, or be showing a profit of $325. Remember, the $22.50 was just the break-even point if the position is held until expiration.
The position is now outright long. This also highlights two main advantages of a back spread vs. a straight vertical call spread: The back spread's value increases as long as the underlying stock price rises, a vertical spread's profits are limited; a back spread can be pulled off for a profit relatively quickly, while the vertical spread usually must be held until expiration to realize its full value. The advantage of a back spread over simply buying calls is the reduced cost and less exposure to time decay. The risk is the stock staying in the "dead zone" between strikes, but this is usually no greater on a risk/reward basis than the cost of buying options outright.
Having a positive gamma becomes a powerful leveraged trading tool and allows you to react offensively to any large price move. You'll be looking to lock in gains and maximize profits rather than falling back on your heels and trying to defend a losing position if the underlying price moves or volatility increases. Having a positive gamma, a position that gets longer or one in which the delta increases as price rises -- or gets shorter and has a more negative delta as price falls -- allows you to trade from a position of strength.
A possible example of this: As the stock crosses above the higher strike price (moving those long calls into the money), you sell some shorted dated calls to take advantage of their higher theta or more rapid time decay to bring the position back to delta neutral. Just be sure not to short more calls than you are long. This will allow you to take some money off the table while maintaining further upside profit potential.
Nothing Gained, Nothing Lost
Many of the hardest-hit stocks were high-multiple names that failed to deliver the necessary earnings or revenue growth to justify their high prices. The short list of names included
Dollar Tree Stores
If these companies can put up decent third-quarter numbers and accelerate growth in revenue and earnings, their shares could quickly regain the ground lost in the first half of the year. If they fail to show any improvement, I suspect the stocks could hit new lows.
Establishing back spreads on some beaten-down names is a good way to bridge the gap between the summer selloff and what is shaping up to be a make-or-break third quarter for many companies.
Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from 1989 to 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to