Breaking Out With a Back Spread

Last month, my strategies for a sideways market hoped to ride the gentle and unobtrusive wings of an options "butterfly" position on the belief that the market would be fluttering harmlessly around this spring.

That article's suggested strategy of the long June 35/36/37 butterfly (buying one $35 call, selling two $36 calls, and buying one $37 call in the Nasdaq 100 Trust ( QQQ)) is doing just fine; the QQQs closed Wednesday at $36.20, a mere 40 cents lower, which is much closer to the maximum profit point than when it was "initiated" three weeks earlier.

Butterflies are often referred to as "vacation positions" because they are a fairly benign way to participate in the market; the position has limited risk/limited reward and requires little or no adjustments during the holding period. The idea is that you establish it, forget about it and hope that you come back on expiration day to find the prices of the underlying stocks trading at the same level you left them.

But recently, some incredible percentage moves in individual issues and the building tension over interest rates suggests this range-bound trade (or consolidation period) can't last forever.

So this week I'll shift my focus to the ratio back-spread strategy. It's a position that still enjoys a relatively low and limited risk, but offers unlimited profit potential from the movement in the underlying security's price and an increase in the implied volatility of its options. And it's one of the most powerful options positions you can establish when anticipating a significant price move.

The ratio back spread consists of selling an at-the-money option while simultaneously buying out-of-the-money options on a ratio basis. The idea is to buy the greatest amount possible of OTM options for the price of the ATM options sold, creating a position with the highest long/short ratio for as little money as possible.

For example, if XYZ is trading at $50 and the June $50 call was trading at $2, and the June $55 call was $1, you could sell one $50 call and buy two $55 calls, creating an even-money 1-to-2 back spread.

Going Away, but Retuning to a Different Place

The last time I mentioned back spreads was more than a year ago in this article, when I was trying to take advantage of sharp moves in a small time frame just ahead of earnings expiration. I screened for stocks with cheap options, as well as catalysts that would cause short-term spikes in both price and implied volatility.

The results were only marginal: Just one of the three positions yielded a small profit (the other two basically broke even). Looking back, I realize I suggested a strategy that involved several things I preach to avoid -- buying cheap long-odds options with a short time horizon that resulted in a position that required constant monitoring and a quick trigger finger. It was attractive because with minimal time remaining, the out-of-the-money options were cheap enough to create even-money back spreads with ratios of 1-to-4 or greater.

But now I've realized taking a more measured approach by applying a longer time frame would create not only a less labor-intensive position but potentially increase the probability of a profit.

One of the most important ingredients of establishing an attractive back spread position is low implied volatilities, especially for those stocks displaying a "normal" skew, which means the closer-to-the-money options have higher implied volatility than the out-of-the-money strikes. This allows for creating a higher ratio (long options/short options) for the lowest possible cost.

Right now, implied volatilities in the broad market (as measured by the VIX) and in many individual issues, are at historically low levels. When my above-referenced article on back spreads was published on Feb. 12, 2003, the VIX was 37; now it's around 15. Even though each stock is different, it seems like an increase in overall implied volatilities holds a higher probability than a further decline.

Backing EMC Into Storage

This time, let's use January 2005 calls, which give us a nine-month time horizon (making the options still technically LEAPs). The premise is that the expanded time period will not only allow for a more substantial price move, but also the likelihood that implied volatilities will have lifted off of their eight-year lows. EMC ( EMC) strikes me as a good candidate for establishing a call back spread. With shares in the data storage company trading at $11.75 on Wednesday, one possible back spread would be to sell one January 2005 $10 call for $2.60 per contract and buy two $12.50 calls for $1.25 each (a total of $2.50) for a net credit of 10 cents, or $10 a spread. (Consider this an even-money position when the cost of commissions is included).

The table below shows the costs as well as the profit and loss for various price points in EMC at the January 2005 expiration. Note that it makes no assumptions about changes in implied volatility. While EMC is getting beaten down in an out-of-favor group, it remains one of the best-run companies in the sector, and it doesn't seem unreasonable to believe the stock could double in the next nine months.

EMC Back Spread
Values with EMC at Various Prices
Position Credit/Debit $9.00 $12.50 $15.00 $20.00
Sell 1 Jan. $10 Call $2.60 $0 ($2.50) ($5.00) ($10.00)
Buy 2 Jan $12.50 Calls 1.25x2=(2.50) 0 0 5.00 15.00
Net $0.10 $0.10 ($2.40) $0.10 $5.10
Source: TSC Research

The maximum loss is equal to the cost of the spread (in this case 10 cents, or $10 a spread) plus the differential of the strike prices, or $2.50. The advantage of a back spread over the outright purchase of calls is that if the stock falls below the lower strike price, then no loss is incurred. To achieve a higher return, you simply need to spend more (risk more) and increase the ratio through the purchase of additional out-of the-money call options.

For those looking at the ever-popular QQQs, you could establish an even-money back spread in the January 2005 calls by selling one $34 strike at $4.50 and buying two of the $38 strikes for $2.25 each. The maximum loss or risk here is $4, the price differential between the two strikes, which is realized if the QQQs settle at $38 at expiration. If the QQQs finish below the lower strike or $34, no loss is incurred. The break-even point to the upside is $42 -- profit will be realized if the QQQs were to climb more than 16%, or above $42, over the next nine months.

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 steve.smith@thestreet.com.

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