When to use: Call Backspread Option Strategy is used when the investor is bullish on the stock (i.e. the investor expects the price of the stock to rise in the near future).
How it works: Call backspread option strategy uses three option contracts of the same underlying stock, with the same expiry date but two different strike prices. In this strategy, you sell/write 1 in-the-money call options and buy 2 lots of out-of-the-money call options, each with the same expiry date, T.
For example: On 28th August 2013, Infosys share was trading at Rs. 3,120.30. You decide to sell/write 1 in-the-money call options at a premium of Rs. 95.30, with a strike price of Rs. 3,000, expiring 26th September 2013. You further buy 2 out-of-the-money call options at a premium of Rs. 34.85, each with a strike price of Rs. 3,150, expiring 26th September 2013.
Risk/Reward: In call backspread strategy, your maximum risk will be limited as the trade involves selling a call option at a lower strike price and buying 2 call options at a higher strike price. The maximum reward/profit which you stand to make from this trade will be unlimited. Even if the stock moves down you won’t incur any loss. On the other hand, if the stock moves higher, the profit potential will be unlimited (i.e. based on how much the underlying stock price appreciates). The maximum loss (Rs. 124.40 in this example) will be incurred when the stock is at the long call strike price on expiry, calculated as:
Maximum Loss = Strike Price of long call (Rs. 3,150) – Strike Price of short call (Rs. 3,000) – Net premium received (Rs. 25.60) = Rs. 124.40
For Short Call Option: If the price of the share stays below Rs 3,000 (i.e. the strike price of the short call option) until expiry, you will retain the entire premium amount (i.e. Rs. 95.30). If however the price rises above Rs. 3,000, the buyer of the call option may exercise his option and make a profit based on how far above Rs. 3,000 does the stock price rise. From the perspective of the seller of the call (you), you will start suffering a loss once the stock price rises above Rs. 3,095.30 (i.e. the strike price + premium).
For Long Call options: If the price of Infosys rises above Rs. 3,150 (i.e. strike prices of the long call options), you can exercise your options, but the price of the stock must rise above Rs. 3,184.85 (i.e. strike price of the long call options + the amount of premium you paid for each option) for you to exercise your option and make a profit.
The table below shows the net payoff of call backspread option strategy at different spot prices on expiry date:
How to use the Call Backspread Option Strategy Excel calculator
Just enter your expected spot price on expiry, option strike price and the amount of premium, to estimate your net pay-off from the Call Backspread Option Strategy.
Note: The example and calculations are based assuming a single share though in reality options are based on lots of many shares. For example Infosys’ option contract is for 125 shares. Accordingly the net premium received will be Rs. 3,200 for 3 lots (i.e. 0.1 *4000) in our example.
Also Note: Unlike the buyer of an option who only pays the premium to buy the option, the seller of an option must deposit a margin amount with the exchange. This is because he takes an unlimited risk as the stock price may rise to any level. In case the price rises sharply above the strike price, the exchange utilises the margin amount to make good the profit which the option buyer makes. The amount of margin is decided by the exchange and it typically ranges from 15 % to 60 % based on the volatility in the underlying stock and market conditions. In the above example, as a seller of call option, you will have to deposit a margin of Rs. 46,875 (i.e. Strike price * Lot size * 12.5 %) for selling/writing a lot of Infosys’ option contract. Note that the total value of your outstanding position in this case will be Rs. 3,75,000 (i.e. strike price * lot size).