A call backspread is set up to take advantage of a bullish outlook on an underlying. The position can be net debit or net credit spread. This week, we discuss how a net credit position may impact the profitability of a backspread.
The trade-off
A call backspread involves shorting one lower strike call and buying two higher strike calls (or in multiples thereof). Often, the position is set up to be delta neutral. That is, the deltas of the long calls must equal the deltas of the short calls. Practically, it is difficult to set up a delta-neutral spread because of option strike schemes available on the NSE.
To set up a backspread for a net credit, the higher strike long call must be far away from the lower strike short call. For instance, you can set up a call backspread with 17700/17900 next-week Nifty calls. With the Nifty Index currently at 17681, this backspread can be set up for a net credit of 41 points. However, the position will not be delta neutral, as the long deltas will be less than the short delta.
Also read: Mastering Derivatives: Short put or long call?
It is optimal to set up a net credit backspread when you expect the underlying to move past the higher strike. The maximum profit will be the difference between the underlying’s spot price and the higher strike plus the net credit minus the difference between the strikes. The backspread will gain (net credit) even if the underlying trades below the lower strike and all the options expire worthless.
There are two factors to consider in relation to net credit backspread. One, if the underlying trades above 17900, the 17700 call will have low liquidity as it would be in-the-money (ITM). You may still be able to close your short 17700 call but at a price that may not be beneficial (the implied volatility could be high).
Also read: Mastering Derivatives: Delta matters for directional bets
And two, the position’s maximum loss occurs when the underlying trades at a price equal to the higher strike. The loss will be the difference between the strikes less the net credit. The point is that the higher strike must be far away from the lower strike if you want to set up a net credit position. This also means the maximum loss will be typically greater for net credit position than for backspreads with net debits. For instance, the maximum loss for 17700/17800 net debit spread will be 131 points compared to 159 points for the 17700/17900 net credit spread.
Optional reading
It is optimal to set up credit backspreads with longer expiration dates. For example, the 17700/17900 backspread expiring on May 4 instead of next week.
The objective is to allow more time for the underlying to move up. Note that time decay will lower the gains for net credit backspreads and increase the losses for net debit spreads.
Net credit backspreads typically benefit from increase in implied volatility when the underlying moves up. The lower breakeven is lower strike plus the net credit.
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