The backspread option strategy covers a number of setups, all designed to profit from volatile market conditions. Backspreads include strategies such as the Long Straddle, Long Strangle and Ratio Spreads where the implied volatility in the short positions is greater than the IV for the long positions.
Backspreads are the opposite of frontspreads, which are option strategies more suitable for neutral market conditions. Frontspreads include setups like the Iron Condor, the Butterfly Spread and Long Iron Butterfly, as well as the Short Straddle and Strangle. Frontspreads also include ratio spreads, which should not be confused with ratio backspreads.
Backspread Option Strategy - Taking Advantage of Volatility
The best times to employ backspreads is when you expect the price action in the underlying asset to become volatile in the near future. Fortunately, this is often highly predictable. The idea is to enter the backspread when the long (bought) positions are relatively cheap and the short positions (if applicable) are relatively expensive due to a higher implied volatility (IV) in the premium. As IV increases, which usually occurs when the underlying begins to move rapidly (though not necessarily so) your positions will show a profit. In most cases, the profit potential is unlimited.
There are many factors which can trigger volatility in price action. Upcoming earnings reports, news releases, court rulings, executive management changes and a host of other business events can affect the price of a stock. Some of these are predictable, others aren't. Applying a backspread shortly before an event that may cause price volatility can realize wonderful profits.
Risks in the Backspread Option Strategy
Should the underlying asset price remain stagnant for a period of time, the value of your backspread will deteriorate. It is rare for stocks and commodities to remain stagnant for extended periods, but it does happen. If you're using this strategy, you should first be aware of the maximum loss versus potential rewards. Fortunately, maximum potential losses can be precisely calculated for any backspread option strategy you choose. Pharmaceutical companies are often a good choice for the backspread strategy, particularly if a ruling is about to be made about the approval or otherwise of a new drug.