In our quest to understand trading options for income, we take a look at an option strategy called the Backspread.
The Backspread is a combination of a credit spread plus an extra long option. With the proper proportion and location of the strikes, the Backspread can be initiated with a credit and a POP (probability of profit) of around 65-80 percent.
For example (see picture), if XYZ is currently at $530 we can initiate the following Backspread on an option chain with 14 DTE (days till expiration): -2 Call 540 / +3 Call 550; our credit will be $2.20 with a POP of around 76 percent.
As per the Risk Profile, if the price of XYZ stays below $540 by expiration, then the profit is the premium collected, $220; above $568 the profit is one-cent or more (the upper end is unlimited). If the price by expiration falls within those two levels, the max loss would be $1,746; but since the loss could vary, we took the midpoint of $554.40 ( (567.83 - 540.95) / 2) and determined a loss figure of $1,340.
Looking at the Greeks: -14.2 delta; -0.23 gamma; -2.1 theta; 1.1 vega. Note: as price declines, theta will go positive.
This trade has a minimum reward to risk ratio of 0.164 (220 / 1340) with a POP of 76 percent. Its maximum reward to risk ratio is unknown, since it has unlimited upside profit potential.
Is this a good trade? One approach to determining this is to roughly determine the expected return by using the minimum profit potential of $220.
We calculate expected return by taking the product of minimum premium and POP, and adding the product of loss and POML (probability of max loss). The expected return is -$101.60 ( ($220 x 0.76) + (-$1,340 x 0.24) ).
Expected return can be used to compare separate strategies, and as a guideline for rejecting a strategy. Our guideline is that we do not initiate a trade if the expected return is negative.
In conclusion, while the Backspread has appeal with a high POP, its negative expected return is discouraging.
If you would like to learn more about options, and how to generate consistent weekly income trading options, go to Options Annex.