- 2001: Volume 10, No. 3 Puts & Calls: Hedging Call Ratio Backspreads with Calendar Spreads

Last week, I attended the Optionetics seminar in Atlanta, my hometown. Although I’ve been to all levels of the Optionetics seminars several times, I still manage to learn from each new seminar I attend. Sometimes it’s a matter of seeing a strategy that I haven’t used in a while taught again. Other times it’s a matter of meeting other traders and sharing ideas, or just hearing Tom Gentile and George Fontanills talk about what’s working best in the market right now.

Tom and George taught a very powerful strategy called a Call Ratio Backspread [CRB], sometimes referred to as a vacation trade for its low maintenance requirement, low risk and unlimited profit. Even though the strategy is low-risk, I still prefer almost no risk, so I thought about ways of hedging out the limited risk that exists. This can be accomplished, as with just about any Optionetics strategy, by overlaying another strategy on the primary trade.

In a 1x2 CRB, one call option with a lower strike is sold, and two call options with a higher strike are purchased: hence the 1x2 ratio. The option that is sold ideally pays for the two that are purchased, or, at the very least, covers most of the cost of the two options purchased. The theory is that if the stock moves up nicely, the profit in the two options purchased will make up for the liability in the one option shorted (sold) and profit in the total trade is unlimited. To the downside, if the stock either fails to move or falls apart, downside risk is very minimized and quantified before placing the trade.

I’ve worked out an example with Nortel. Let’s walk through it together. One important note is that I’m going to build it as a neutral-to-bullish trade. Typically, the option sold is below the current stock price, hence, "in-the-money," and the options purchased are around the current stock price "at-the-money." I’m going to sell and buy options that are higher than the current stock price "out-of-the-money."

Let’s create a 1x2 CRB using one short 35 call for 2003 and two long 45 calls:

• The margin is 10 ($1,000/contract), and the cash outlay just less than one ($100/contract).
• Remember that each contract represents 100 shares.
• The breakeven at the trade’s expiration is 56 (I don’t like that, it’s too high for my tastes).
• In January 2003 (the black profit/loss line), if the stock should reach 80, the profit would be a little less than $2,500 (keep this in mind as you read further down).

Here it is in Figure 1. The black line shows the profit/loss at expiration, but the red, blue and green lines show what the profit picture looks like between now and then. With CRBs, you typically don’t hold them to expiration because you’ve purchased more time value than you’ve sold, so if the trade doesn’t perform the way you’d like it to by the time you’re one-third or two-thirds to expiration (i.e., the blue or green lines), you’d want to exit the trade, minimize your loss, and be on to something that may work better. You don’t want to see all the time value in your purchased options evaporate. The black line shows the worst-case example if the stock stagnates in the mid-40s and you hold it to expiration. With CRBs, and following the Optionetics principles, you should never get to this point.

Figure 1:

This picture made me think about what I could do to hedge the risk, even if I held the trade to expiration for some reason and the stock stagnated or fell backward unexpectedly after being in a nice profit range. I thought about adding a calendar or two to see what could be done to hedge.

In Figure 2 I’ve added two 2003/ 2002 40-strike put calendars to every one CRB. A put calendar consists (in this case) of buying a 40-strike put for 2003 and selling a 40-strike put for 2002. Looking at the curve in Figure 2, I’ve now reduced the maximum risk at the trade’s expiration to $300 and the breakeven is 21. Note, however, that the time until final expiration on this curve is now January 2002—the expiration date of the short 40-strike put. Looking at the curve in Figure 1, which just shows the CRB with an expiration of January 2003, we can approximate the time frame of January 2002 as somewhere between the green and blue lines, and in January 2002 the price of the stock at which we see a breakeven on the CRB trade is about $30, which is where a line that runs midway between the green and blue lines would cross the vertical zero profit line. What we now realize given this evaluation of the trade is that the calendar spread added to the Call Ratio Backspread brings the breakeven down by nine points in January 2002 (calculated by the difference in the breakeven points for January 2002, 30-21=9).

Figure 2:

By adding a calendar spread to the trade, we’ll have to put a little more money into the trade (i.e., the cost of the calendar spread), but there’s a benefit: the worst case at expiration now is a loss of just over $300 instead of $1,000. Take a look at where things stand right now with the stock. The dark black horizontal line shows the price today, 16 5/8. If the stock never moved and we never adjusted the trade, the loss at expiration would be less than $200 (look at the intersection of the horizontal black line with the bold black profit/loss line. It appears to intersect at -175 or so, we’ll call it -200). The calendar seems to have hedged things well in the context of maximum possible loss.

In Figure 3 I’ve changed the scale on the graph so you can see the profit/loss picture through a wider range of stock activity. The trade has not changed. Take a look at the profit picture if the stock takes off and reaches 80 by January, 2002: almost $5,000 profit at 80! In the graph of the CRB in Figure 1, the profit at 80 in January, 2002 (between the green and blue lines) might be around $3,500. So now we have a better risk profile and much better profit picture!

Figure 3:

Figure 4 is a screen shot of exactly what went into the trade in the scenario above, with the two calendars added. Keep in mind that these prices were in effect several days ago when I actually created the trade on optionsanalysis.com, and will not be exactly the same if you take a look today.

Figure 4:

If you remember, I used a ratio of two calendar spreads overlaid on each CRB in the example above. What if we do it with just one calendar spread? It then costs $200 cash to do the trade (as opposed to $300), the margin on the CRB is still $1,000, and breakeven is 23. So we lose a little of the advantage of the calendar spread (the breakeven went up a smidgen, from 21 to 23), but it lowers the cost of the overall trade. Graphically, it looks like Figure 5, below—which is Figure 2 redrawn, with just one calendar spread to hedge the risk of the CRB, instead of the two used in Figure 2. The result is lower cost, and a slightly higher breakeven.

Figure 5:

Here’s the profit picture again (see Figure 6) up through 80: identical to Figure 5, with a different scale along the left vertical axis, to show the P&L along a broader range of price activity in the stock. Profit is a little more than $4,000 at 80. The reason the profit at 80 is a bit lower in this trade is that we have one less calendar trade making a profit for us in this example.

Figure 6:

Just for curiosity, let’s look at the 40-strike 2002/2003 put calendar spread by itself (see Figure 7). This is a look at the hedge that was applied to the original trade in Figure 1 to offset the risk of the CRB. As I suspected, it adds about $600 profit at 80, which is large enough to explain the difference I just mentioned between just above $4K and just under $5K (I was just using approximate figures in the profit estimations in previous paragraphs).

Figure 7:

Is there a case to be made for just doing the calendar portion of the trade? Quite possibly, especially since the calendars don’t require a margin set aside, and each contract of this trade could be done for $90 plus commissions.

One caveat is that I did the calendars with puts because they cost 90 cents (/contract), but they are subject to early assignment if the stock drops, if volatility plummets, of if the stock simply stagnates.

Let’s see them done with calls instead (see Figure 8). The use of calls eliminates assignment risk if stock stagnates or drops. This trade costs more than its put spread version, but comes with a larger maximum profit. Now they cost $1.75 ($175/contract)—nearly twice as much, but there’s no risk of early assignment on the downside. On the upside, there is risk of early exercise, but it’s remote. The stock would have to reach several hundred dollars!

Figure 8:

Again, one thing to keep in mind is that by adding the calendar trade, all the charts above are for the time frame of January 2002, which no longer corresponds to the original CRB graph, which was for 2003. To compensate, look at the original CRB and imagine another line drawn somewhere between the blue and green lines, which would correspond to a timeframe of January 2002.

What’s the best choice here—Call Ratio Backspread, Call Ratio Backspread with a calendar spread, or simply a calendar spread by itself? There’s no "right" answer. It’s a matter of preference for risk, reward, complexity of trade, strategies you’re familiar with, and more.

The lesson to be learned here is that it is possible to take any trade and find a way to limit your worst-case possible risk. You might need to invest more in the trade, as we saw with the addition of the calendar trade to the original CRB, and you might even reduce the rate of return (profit per dollar invested in the trade). But the worst-case risk will be hedged, and that’s the key to successful trading over the long-term—to protect yourself from major losses and/or getting wiped out, and make profits consistently and steadily over time.

Happy (and safe) trading!

Ed Hecht is a staff writer and trading strategist for www.optionetics.com—Your Options Education Site. You can reach him via e-mail at ehecht@optionetics.com