Back Ration Spreads

A look at how a Back Ratio position can be used.

In previous articles we have discussed how calls (or call spreads) can be bought to take advantage of an upwards (“long”) move, and puts or a put spread bought for a downwards (“short”) move. For these directional positions the price of the stock or index MUST move in the direction chosen to generate a profit. We have also examined how when a top is forming you can sell a call spread to take advantage of a sideways move or pullback. Likewise when a bottom is forming a put spread will take advantage of a sideways move or bounce. When you sell premium (call or put spreads) you have the advantage that the price would need to move against you for it to become a loss.

Today I want to use a stock that I highlighted today and how a mixture of bought and sold options can be used to create a low risk position. First we will take a look at the longer term half of the Time Frame Analysis on this stock.

This stock is trying to turn up on the monthly chart, showing potential for the price to retest the previous highs at 45. The weekly chart is stalling a little at the highs from last week and also late June at 40. This weekly chart is making it a little questionable if the price will be able to break this resistance at 40.

I want to take a moment to examine some possible positions that could be taken.

For a “long” position we would need to see the price break thru this resistance at the 40 area, and we would then need for the price to continue moving up to produce a profitable position. If the price can not break 40, then an entry would not be made.

The price is not moving down, and is not showing any downwards potential, so we would not want to enter a “short” position at this time. There are a few “ifs” that could happen to change the expectations of this stock, but what is important is right now the longer term charts are not showing potential for a short position to generate a profit.

The price is 5 points away from 35, so there is not any premium left at that strike that can be sold, and the same thing applies to trying to sell the 45 calls, there just is not enough premium to sell. The 40 strike is right in the middle, and the risk to sell either calls or puts at the 40 strike is that the price will move to and perhaps past 35 or 45.

It did not take much to go thru the basic positions and see the only one at this time that would be showing any possibility is a “long” position, and that is only if the price can break thru this resistance at 40.

So now we can get creative and look at purchasing a Back Ratio. Specifically by selling 1 Dec 40 Call and buying 2 Dec 42.50 calls for a 45¢ credit, and a margin requirement of $200.00

What we did here was sell a call spread, but also bought an extra call. Here is the risk profile of the position as it will appear right before the Dec. expiration. Because of the time erosion of the bought calls, the risk profile of today is much different than what it would be right before this position would expire, thus the use of the profile for Dec. The Dec. strikes were selected to allow the price not just 3 weeks to make a move, but rather to allow it 7 weeks:

This is what is interesting about this position. What if we are wrong about the upwards potential, and the price can not break above 40, or if it does peek above it can not stay above it, and begins to move lower. If you have a “long” position this would result in a loss. But with this Back Ratio because it was entered for a credit, if we are wrong it will result in a $50 PROFIT!

With the 7½ weeks we have ahead of us, we want to see this stock move up to test the previous highs near 45 and breakout above that level and just run. And if it can do so, then we have a great reward potential because we bought more calls than were sold. The reward is limited to how far the price of the stock can run before the Dec. expiration.

WOW! that sounds really great, we can make a profit if we are “wrong” and the price goes down, and we can make a bigger profit if the price breaks above the previous highs, but what about that “V” that we have between 40.50 and 44.50 where the line drops below 0 to represent a loss, with a maximum loss of $200 if the price is at 42.50 on expiration day?

That 44.50 is right in the 44-45 area where we have the previous highs on the monthly chart. This position will make the best profit with a breakout above that resistance. IF the price fails to break that resistance, then the monthly chart will be forming a top, and it could be stuck between the 40 to 45 area for a period of time. So what we would want to do is monitor the price as it tests the previous highs at 45, and IF it can not breakout, then we look at the position characteristics we talked about just a few minutes ago, and we see that when a top forms, you can sell a call spread to take advantage of a sideways move or pullback.

Because we are talking about a situation of “what if” the price is near 45 (and how near it) we also have the “when”, how long before that Dec. expiration. This makes it hard to say with certainty what the option prices will be with these variables, so for the answer to this question of what we could possibly do should the price not breakout above the previous highs, we have to “guesstimate” and come up with a rough idea, and if this situation does present itself, at that time we would fine tune it with the actual numbers at that time.

IF the price is unable to breakout above the previous highs (or if it just peeks above them and falls back) AND ONLY IF the price fails to breakout to new highs, we would look at selling the Dec. 45/47.50 call spread. We would look at selling it enough times to eliminate the possible $200 loss that the above profile shows. Or at least reduce that loss to a very small amount that would be near breakeven. IF we were able to sell the 45/47.50 call spread for 40¢ we would want to sell it 5 times (5 contracts) and it would give us the following risk profile:

With the Back Ratio, and the 5 sold call spreads, we now have a breakeven at 45.50 that if the price of the stock moves above this level we would stop out and prevent a loss from occurring. But while the price remains below 45.50 (and the only reason we sold the call spreads was because the price was forming a top!) we will NOT lose any money on this position. Our worst case is if the price expires at 42.50 where we pretty much so just break even. But if the price does not expire at that level we have the potential to make up to $250.00 profit.

The purpose of this article is to show how a trading plan can be laid out. In this article we see the entry and position, and WHY this position was selected. We know where the risk is at, and we even have a back up plan IF the price fails to break above the resistance of the previous highs. This article also shows how a Back Ratio can be used if there is potential for a directional move, and it can also even generate a profit if you are “wrong”. There is a zone where the back ratio can create a loss, but by being flexible and adapting to a changing situation we were able to devise a plan of action that takes this zone into consideration.

This also illustrates the importance of know your time frame and being able to see multiple time frames at the same time. The Time Frame Analysis shows the longer term perspective that we saw in this article and also presents the shorter term charts at the same time. The shorter term charts were omitted from this article so it would not “muddy the waters”. This position is looking at expectations that are 7½ weeks in the future and require the longer term charts to be able to get the proper perspective.

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