You can think of this strategy as a call backspread with a twist. Instead of simply running a back spread with calls (sell one call, buy two calls), selling the extra call at strike D helps to reduce the overall cost to establish the trade.
Obviously, when running this strategy, you are expecting an enormous bullish move. So it’s a strategy for extremely volatile times when stocks are more likely to make wide moves in either direction.
When implied volatility rises, in general option prices go up independent of stock price movement. That’s why we need some help to pay for the strategy by selling the call at strike D, even though it sets a limit on your potential profit.
Ideally, you want to establish this strategy for a net credit whenever possible. That way, if you’re dead wrong and the stock makes a bearish move, you can still make a small profit. However, it may be necessary to establish it for a small net debit, depending on market conditions, days to expiration and the width between strike prices.
The further the strikes are apart, the easier it will be to establish the strategy for a credit. But as always, there’s a tradeoff. Increasing the distance between strike prices also increases your risk, because the stock will have to make a bigger move to the upside to avoid a loss.
As with back spreads, the Profit + Loss graph for this strategy looks quite ugly at first glance. If the stock only makes a small move to the upside by expiration, you will suffer your maximum loss.
However, this is only the situation at expiration. When the strategy is first established, if the stock moves to strike B, this trade may actually be profitable in the short term if implied volatility increases. But if it hangs around strike B too long, time decay will start to hurt the position.
For this to be a profitable trade, you generally need the stock to continue making a bullish move up to or beyond strike D prior to expiration.
Maximum Potential Profit
Potential profit is limited to strike D minus strike C minus the net debit paid, or plus the net credit received.
Maximum Potential Loss
Potential risk is limited to strike B minus strike A plus the net debit paid, or minus the net credit received.
Break-even at Expiration
If established for a net debit, the break-even point is strike C plus the net debit paid.
If established for a net credit, there are two break-even points:
- Strike A plus the net credit received
- Strike C minus the net credit received
TradeKing Margin Requirements
Margin requirement is equal to the difference between the strike prices of the short call spread embedded into this strategy.
NOTE: If established for a net credit, the proceeds may be applied to the initial margin requirement.
Keep in mind this requirement is on a per-unit basis. So don’t forget to multiply by the total number of units when you’re doing the math.
As Time Goes By
The net effect of time decay depends on where the stock is relative to the strike prices and whether or not you’ve established the strategy for a net credit or debit.
If the strategy was established for a net credit:
- If the stock is below strike A, time decay is your friend. You want all of the options to expire worthless so you can capture the small credit received.
- If the stock is between strike A and strike C, time decay is your enemy because your chance to make a profit will be eroding along with the value of your two long calls. Time decay will do the most damage if the stock is at or around strike B, because that’s where your maximum loss will occur at expiration.
- If the stock moves above strike C toward strike D, time decay becomes your friend again because you need it to erode the value of the short call at that strike to achieve your maximum profit.
If the strategy was established for a net debit:
- If the stock is below strike C, time decay is the enemy because your chance to make a profit will be eroding along with the value of your two long calls.
- As the stock moves above strike C and approaches strike D, time decay becomes your friend. You need it to erode the value of the short call at that strike to achieve your maximum profit.
After the strategy is established, the effect of implied volatility depends on where the stock is relative to your strike prices.
If your forecast is correct and the stock is approaching or above strike D, you want volatility to decrease. A decrease in implied volatility will decrease the value of the short options at strikes A and D and increase the overall value of your position.
If your initial forecast was wrong and the stock has stagnated around strike B, you want implied volatility to increase for two reasons. First, an increase in implied volatility will increase the value of the near-the-money options you bought at strike B more than it will affect the value of the options you sold at strikes A and D. Second, an increase in implied volatility suggests an increased possibility of a larger price swing (hopefully to the upside).
If you established the strategy for a net credit and the stock price is below strike A, you may want volatility to decrease so the entire spread expires worthless and you get to keep the small credit.