Creating the Back Spread
Specifically, a back spread is created by selling an option and buying a greater quantity of an option with a more out of the money strike price. For example, if a futures contract's current price is 100, a back spread could be created by selling a 100 put and then purchasing two 90 puts.
The option sale at the first strike price is intended to finance the purchase of the options that are farther away from the money. By combining the sale and purchase, the strategy also creates a broader array of possible outcomes than a simple, outright purchase of the out of the money options.
Depending on current market conditions and the goals of the trader, a different ratio of sold vs. purchased options can be used. The trader can also vary the strike prices for the sold and purchased options to create different degrees of risk, loss and credit.
Back spreads are used when the trader anticipates an aggressive and extended move in the direction of the option purchase.
- If the market moves as intended, then the purchased options rise more rapidly in value than the near option that was sold. One of the long options limits the losses that the short option can sustain. The remainder of the long options can increase in value until the position is offset. Profit on those remainder options is limited only by the distance the market moves before offset.
- If the market moves away from the intended direction and does not return to the sold option's strike price before expiration, then the position is offset or expires with no change from the setup. Whatever small profit or loss that was realized at the time of establishing the position, is the net result of the trade.
- If the market moves in the anticipated direction, but does not go far enough to pass the long options' strike price or does not move in the correct direction quickly enough, the value of the long options may not be enough to offset the loss sustained by the short option. The gross loss in this case could be as much as the difference in strike prices between the long and short options.
- Ratio and Back Spread Essentials. RedOption.