Positive back spread

Market view

The most appropriate time to establish a positive back spread strategy is when you believe there will be a heavy rise in a certain stock or index up to a certain future date.
 

Construction

A positive back spread is established by writing call options at a lower strike price whilst simultaneously buying twice as many call options with a higher strike price but with the same expiration month. The advantage, compared to establishing a positive price spread, is that you have an unlimited profit potential. The advantage compared to just buying naked call options is that establishing the position demands a lower cost of capital. On the other hand, your break-even will be higher and you will have margin requirements.


Example:
It is the 15th May. Bank stock A has, in a short period of time, dropped 20 percent to 200 due to speculations that the US central bank will raise the interest rate at their upcoming meeting. However, your view is that there is no need to worry and you assume that the interest rate will be left unchanged. You think this will lead to falling market interest rates which, in combination with summer usually being a good market period, will give bank stock A potential to rise up to 20 percent. This equals to a potential rise in the stock of up to 240 until the expiry day on the third Friday of July.

Since you do not want to completely ignore the risk that the interest rate will be raised after all, you find it too risky to just buy the stock or naked calls. Instead you choose to write 10 call option contracts with a 200 crowns strike price and receive premiums of 1,400 per contract. At the same time you buy 20 call option contracts with a strike price of 210 at a cost of 900 per contract. This results in a net cost of (10 x 1,400) – (20 x 900) = 4,000. 

 

Results on the expiration day

What the payoffs are from different stock price levels is shown in the table below. 
 

Profit, loss and break-even

The maximum profit from the above positions is limited since there is theoretically no upper bound for the rise of a stock price.

The maximum loss is 14,000. This will occur at a closing price of 210 and is calculated as the difference between your written call options with strike price 200 and your purchased call options with strike price 210, plus the net premium of 4,000 paid.

The break-even point of your position is at a stock price of 224. If you instead had only bought the call options with a strike price of 210 for 900 per contract, your break-even would have already been at a stock price of 219. 
 

Profit realization

The positive back spread strategy has the advantage that with correct market opinion you can realize the majority of the profit before the expiry day. This is due to the fact that the greater the stock rise, the more in-the-money the written options will be, and the less time value they will contain. However, the purchased options will, with correct market opinion, be closer to pari than the options written and thereby contain more time value.
 

Follow-up and protection

The main advantage with establishing a positive back spread is that you can not only have an unlimited profit potential, but you can also often avoid losses if you have incorrect market opinion. If you notice that the market, contrary to your opinion, starts to move down or stands still, you have several alternative ways of acting, depending on your new reviewed market opinion and your risk aversion. For example:

 

1. Close the position and realize with a smaller loss. If the stock price has declined and you still have a very positive market opinion, you can use the decline as an opportunity to establish a new positive back spread from a lower level.
    
2. If you think that the stock price will continue to decline, or at least not rise over 200, you can sell half of, or all of, your purchased call options with strike price 210. If you choose to sell all of your call options your theoretical risk of loss will be unlimited if the stock price begins to rise. One way to protect yourself in such a situation is to either buy back the written options or to buy an equal number of stock futures to the stock options you have. It is worth observing that at a very quick rise it may be difficult to be able to effectively protect naked written call options. In addition, your futures may incur a loss if the stock price should turn down again.

 Advantages with a positive back spread 

• Unlimited profit potential
• Lower cost of capital compared to a purchase of call options only
• Good possibilities to avoid large losses from an incorrect market opinion

Drawbacks with a positive back spread 

• Usually have high margin requirements
• Higher break-even than a positive price spread or a call option
• Relatively high transaction costs 

Choice of strike prices

Which strike prices to choose depends on the percentage you believe that the stock will rise by, plus what level of risk you are prepared to accept. When you establish a positive back spread the more capital you are prepared to invest the higher the probability will be that the position results in a profit and the lower your break-even point will be. On the other hand you risk losing a larger amount of capital if, contrary to your belief, the stock price falls.

For comparison, we will look at an alternative position to the one used as an example above. You can establish a positive back spread by writing 10 call option contracts with a strike price of 200 at an income of 1,400 per contract, and at the same time buy twice as many call option contracts at a strike price of 220 at a cost of 600 per contract. In this case you will receive a net income of 14,000 – 12,000 = 2000 when the position is established. Your maximum loss now amounts to 18,000 and occurs exactly at a stock price of 220.

In this example you will have two break-even levels. The first level is at 202. At a lower closing price you will, thanks to your net premium, make a profit. But your market opinion is that the stock price will rise, and now a rise above 238 is needed before the position results in a profit.