Backspread (Reverse Ratio Spread)
The term backspread refers to an investment strategy that involves buying more long position options than short positions. Backspreads provide the investor with relatively large exposure to any movement in the underlying security.
Also known as a reverse ratio spread, a backspread is an investment strategy involving both long and short position options. The premium received for selling the short option is used to help finance the purchase of the long options. Depending on how they are constructed, a backspread can profit from either upward or downward movement in the price of the underlying security. Generally, this strategy takes one of two forms:
- Call Backspread: if the investor believes the price of the underlying security will increase in the near term, they can construct a call backspread. With this strategy, the investor buys more call options than they write. The call options the investor purchases will have the same expiration date as those they write; however, the call options purchased will have a higher strike price.
- Put Backspread: if the investor believes the price of the underlying security will decrease in the near term, they can construct a put backspread. With this strategy, the investor buys more put options than they write. The put options the investor purchases will have the same expiration date as those they write; however, the put options purchased will have a lower strike price.
An investor believes the price of Company ABC’s common stock will increase in the near future. Company ABC’s stock is currently selling at $25.00 per share. They construct a call backspread consisting of the sale of one call option at $30.00 and the purchase of two call options at $35.00. In this example, the premium received for writing the call option offsets the price paid for buying the two call options.
Prior to expiration, Company ABC’s stock rises to $45.00 per share. The investor is assigned on the call they sold and required to purchase 100 shares of stock at $45.00 and sell them at $30.00, realizing a loss of $15.00 per share or $1,500. The investor also exercises their right on the calls they purchased, and buys 200 shares of stock for $35.00 and sells them for $45.00, realizing a profit of $10.00 per share or $2,000. In this example, the investor’s net profit would be $2,000 – $1,500, or $500.