Call Back Spread
Risk: low
Reward: potentially high
General Description
Entering a call back spread typically entails selling in-the-money calls and buying a greater number of out-of-the-money calls.
The Thinking
This strategy is employed when you are bullish on a volatile stock but want to lower your risk. You buy calls because you are bullish, but then you sell a lower strike price call to lower your risk. This offsets your loss if the stock moves lower. The drawback comes if the stock fails to move or rallies big. One of your long calls will be canceled out by your short call, so your profit potential is lowered.
Example
Let's say IP is trading @ 43.46 and you think it will rally. Buy (2) 45 calls for $1.05 and then sell (1) 40 call for $4.00. Your credit from initiating the trade is $190.
If the stock closes below 40, all calls will expire worthless and you keep the $190.0. Your greatest loss occurs at 45. The long 45 calls will expire worthless and the 40 calls which you sold for 4 will need to be bought back at 5. Above 45, you will only make money on one of the long calls because the other one will be canceled out by your short call.
The image below summarizes the trade with a P/L Diagram. |
