Option strategies that limit your risk: Buy a Backspread

You may consider utilizing the Backspread strategy if a stock you are following suffers a sharp decline, and, a) you feel as though a bounce is imminent but, b) you are concerned that the sharp decline may continue. This is especially true if Relative Volatility is low and the volatilities for out-of-the-money options are lower than the volatility of the at-the-money option. Backspreads offer unlimited profit potential. Additionally, as long as a backspread is entered at a credit it allows you to profit even if your forecast is completely wrong. The tradeoff is that if the underlying stock drifts in a range, this position will lose money.

For example, say XYZ stock is trading at 96, the 95 call is trading at 4 and the lOO call is trading at 1. A trader could sell a 95 call at 4 ($400), buy 3 100 calls at 1 ($100 * 3) and take in a credit of $100. If the stock plunges and all the options expire worthless, the trader keeps the $100. If the stock rises above $100, the trader has unlimited profit potential by virtue of being long more calls than he is short. However, if the stock languishes in the 95-100 range, the 95 call will maintain its premium while the 100 calls will lose their time premium, thus resulting in a loss.

Example:

To set up a Call Backspread, say XYZ is trading at 96,
Sell 1 XYZ May 95 Call @ 4
Buy 2 XYZ May 100 Call @ 1

The trader will receive a credit of $200. If the stock plunges and all the options expire worthless, the trader keeps the $200. A loss will occur if the stock remains range bound between $97 and $103 with a maximum loss of $300 @ $100. If the stock rises above $103, the trader has unlimited profit potential by virtue of being long more calls than he is short.



Example:

To set up a Put Backspread, say CDE is trading at 187,
Sell 1 XYZ May 185 Put @ 5
Buy 2 XYZ May 180 Put @ 1

For this Put Backspread scenario, the trader will receive a credit of $300. If the stock rises above $185, the puts will expire worthless and the trader will keep the $300 credit. If the stock remains range bound between $182 and $178, a loss will occur with a maximum loss of $200 at $180. The long side of the trade will generate significant profits once the share price of CDE falls below $178.



When To Exit Backspreads

Exiting at a Loss
Determine the maximum downside risk and select some percentage of that amount as your stop out point. If that amount is reached or exceeded then one should exit entire position.

Exiting at a Profit

1. If options bought double in price, set 1/2 of your open profit as a trailing stop.
   
2. Raise trailing stop as profits continue to rise.
   
3. If options bought triple in price, close entire position.
   

NOTE: If you are still holding this trade when there is one week left until expiration, you should exit this trade at that time regardless of whether you have a profit or a loss. This position can suffer greatly from time decay in the last week before expiration. If trade is held into last week before expiration and the underlying price drifts back into an unprofitable price range, a profit can quickly become a large loss.