To make a broad generalization, options can serve two purposes -- as a hedge to minimize the effects of price changes or as a tool for maximizing gains as a result of a change in price.
Depending on the circumstances, certain option strategies make more sense than others. Time is the first element that works with today's proposed strategy, a back spread.
Options are expiring on Feb. 21 -- less than seven trading days. The limited amount of time that's left means out-of-the-money options' prices are mainly made up of implied volatility. What little time premium they contain is dwindling rapidly.
By contrast, in-the-money options retain their intrinsic value regardless of the time remaining. This sets up a situation where out-of-the monies can become cheap on an absolute price basis (they may still be expensive on a relative basis if volatility is at extreme levels) compared with in-the-monies.
When Time Is Short
The next key ingredient is the catalyst for price movement. This could be any news event such as an earnings announcement, a merger or even a war. The back spread is a
delta-neutral position with more long options than short options. The more long options that can be purchased while maintaining a delta-neutral or net-credit position, the greater the leverage.
Back spreads become especially attractive when only a week remains until the option expires. Let's look at the
Nasdaq 100 Unit Trust
calls and compare the current ratios that could be achieved in February vs. March.
Each February $23 call sold at $1.30 finances the purchase of six February $25 calls at 20 cents each. But the sale of a March $23 call will finance the purchase of just two March $25 calls at 90 cents each. Prices reflect midday trading with the QQQs at $24.15.
Obviously a 6:1 ratio is far more attractive than a 2:1 ratio, if you're hoping for a large move up. Now let's quickly look at the profit and loss profile for the February position.
The QQQs would need to rally some 8% to reach $26. Definitely optimistic, but not impossible. The main advantage is that the profit is unlimited while the loss is capped at $1.90 per back spread. If the QQQs fall below $23, all options expire worthless and no loss will be incurred.
Back spreads can also be used on individual equities. Suppose you're expecting news to impact the retail sector. As an example, let's look at
, which is scheduled to post a weekly sales update tomorrow and quarterly earnings later this month, and a back spread using February puts. The stock is trading at $27.35.
While the profit and loss profile doesn't look that attractive, it again must be measured against simply "taking a shot" and being outright long out-of the-monies. The short option of the back spread provides some protection if the market moves in the opposite direction you anticipated. Essentially, this is a bet on a large price movement in a short amount of time. A nonevent, while maybe good for the world, is the worst-case scenario for back spreads.
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 May 1989 to August 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