A long ratio backspread, or simply a backspread, is an investment strategy that uses either call or put options to enable an investor to have an infinite profit potential while at the same time limiting losses and even maintaining a chance to profit on the downside. When using a backspread strategy, a bullish investor sells one or more call options with a lower strike price than the current price and simultaneously buys a greater number of call options at a higher strike price than the current price. Conversely, a bearish investor enters a backspread by selling one or more put options with a higher strike price than the current price and simultaneously buying a greater number of put options with a lower strike price than the current price. The ratio of long to short positions is usually 2:1 or 3:2. In both call ratio backspreads and put ratio backspreads, the investor buys more long options, consistent with the direction that he expects the stock to move, than short options.
For example, if an investor expects a breakout of Company X stock in the near future. With the current price at $25 U.S. Dollars (USD) per share, he sells one call option for Company X stock with a strike price of $20 USD for $5 USD. He also buys two call options on credit for Company X stock at a strike price of $26 USD for $2 USD each. For the sale of the first call option, he receives $5 USD per share for 100 shares, a total of $500 USD, which he applies to his obligation of $2 USD for 200 shares on the call options he bought, a total of $400 USD. He immediately has a premium of $100 USD.
If the underlying asset rises as he expects, he profits an additional $200 USD for every dollar the current price increases. On the other hand, if the asset value falls below the lower strike price of $25 USD per share, the investor gains $100 USD for every dollar the asset drops. The maximum profit of the strategy is unlimited, while the maximum loss occurs when the asset price stalls at the higher strike price. In this case, the backspread limits the maximum loss to the costs to set up the backspread.
The put backspread achieves a maximum profit when the price of the underlying asset drops to zero before the option expiration. A maximum loss occurs when the asset price moves to exactly the lower strike price and stays there. When the price of the underlying asset drops below the lower strike price, the investor with two call options gains $200 USD for every dollar the asset drops. Prices that supersede the higher strike price give the investor a return of $100 USD per dollar the asset rises above that strike price.