Ratio Long Call Spread

Yesterday I talked about the 1 by 2 ratio spread where you are net short options, meaning also being short option volatility. Today I'd like to discuss a strategy that is net long options and therefore long volatility. One would do this trade if implied volatility is relatively low and a big move is anticipated.

One thing about up moves is that they tend to crush implied volatility and that gives opportunity. When the market was falling over Fiscal Cliff concerns the VIX (the implied volatility barometer) was 21. Today it is 16.43, a decline of nearly 22%! This makes buying options suddenly much more attractive.

Let's consider a strategy that profits in either an up move or a down move and is less expensive than simply buying a straddle or strangle. This strategy is known as the Back Spread and is best used in times when option premium, particularly call premium, is relatively cheap (like now).

The strategy consists of buying 5 out of the money (OTM) calls and selling one in the money (ITM) to finance the purchase. A sharp move higher makes money, a move lower doesn't hurt, the only killer is if the market rolls over and dies or just incrementally creeps higher.

Let's take the S&P 500 (SPY) using January options. With the SPY trading at 178.90 the 180 calls can be purchased for 1.75. If I buy 5 of those my layout is $175 X 5, or $875. Against that, I sell 1 172 call at 9, giving me a ..25 credit. What can happen?

Any expiration under 180 costs me nothing (I even make .25, less commissions) and my upside potential is unlimited as I am long 4 extra calls.

The danger, as in any options trade, is expiring at my long strike, 180. The calls I bought are worthless while the 172 call I sold at 9 is now worth 8. So, I lose $775 on the trade.

Of course, one does not have to hold on to the position all the way until expiration. There are many ways to adjust as time and price move along. Basically, the position wants a continued move higher ideally coupled with an increase in implied volatility. It's a trader's position and not an investment.