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Here’s a strategy that’s perfect when you’re expecting a stock to make big move to the upside.
It’s called a “call backspread” and it has two components:
- One short at-the-money (or slightly in-the-money) call option, and
- Two long out-of-the -money call options
The thinking behind the strategy is as follows:
The short call nets you a premium that you then employ to pay for the two cheaper out-of-the-money calls. And if you’re right, and the stock flies higher, yes, you lose money on the short side of the trade, but you win big on the twin calls that you got on the cheap.
Let’s look at a real life example to sort out the nitty-gritty.
Below is a chart of high-flier Netflix (NASDAQ: NFLX), a stock whose earnings outperformance vis-à-vis Wall Street’s analysts has been for years both sizeable and consistent.
Stable “earnings beats,” in fact, have made Netflix the premier stock for momentum investors for the last half decade. They’ve also made it a tremendous candidate for the call backspread strategy.
Have a look:
As you can see, over the course of this year Netflix took several leaps higher after earnings reports. And after the first jump (seen on the above chart in red), let’s imagine you decide to act.
Say the stock is trading at $64 (blue circle), and you’ve seen enough to figure that it’s time to employ the call backspread strategy in time to capitalize on the next earnings report in April. You sell the May at-the-money 64 call for $12.10 and buy two May 70 calls for $6.30 each, ending up with a net debit on the trade of $0.50.
And what happens?
Before we get to the honey, let’s consider the bees – or, more precisely, the potential sting if you’re wrong about the stock’s direction.
Here are all the possibilities:
- The stock heads south and closes lower than the short 64 call at expiration. That being the case, all the calls would expire worthless, and you’d be in the hole 50 bucks (net commissions).
- The stock closes above your short 64 call but right at the 70 strike price of your two long calls. That’s the worst-case scenario. Your short call would be in-the-money $6, and you would therefore lose a full $650 ([$6 + your original debit of $0.50] x 100). Remember that one options contract equals 100 shares.
- Break-even for the trade comes at $76, the point at which the short call would be in the money $12 and each of the two long calls would be in the money $6. Above that level, of course, it’s all honey.
Now let’s see what really happened.
With April’s earnings numbers the stock took flight (in black), whizzing right through the break-even level and hitting $82.
Confident that there won’t be any retracement, you let the options play out to expiry (in green), and capture further gains. Netflix closes at $89 and your profit breakdown is as follows:
- The short call ends up in the money $25.
- The long calls are each in the money $19, for a $38 gain.
- Profit = $1250 ([$38 – $25 – original debit of $0.50] x 100)
Sweet!
Note: The trade should only be played on a security that has a realistic chance of an explosive move higher. Failing such a move, the short call will simply eat too deeply into any profits garnered by the two long options, and could leave you with a loss.
Also: Play a put backspread in the exact opposite direction when you’re expecting a steep decline in a stock.
Best of luck!
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