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9 Weeks to Better Options Trading: Back Spreads


Veteran options trader Steve Smith breaks down the back spread.

Editor's note: To help investors profitably navigate the options market, Minyanville has launched "9 Weeks to Better Options Trading," an educational series aimed at increasing trader understanding of the nuts and bolts of options, with an emphasis on real-world applications. In this series, veteran options trader Steve Smith will demystify a range of topics from options pricing to trading strategies to special situations like earnings reports and takeovers. Read the kick-off to the series here.

With market volatility picking up significantly over the past two weeks, the timing on our topics for this series has been pretty darn good.

Following last week's risk/reversal discussion, we are ready to explore another directionally aggressive strategy, but one that also benefits from an increase in implied volatility: back spreads.

A back spread is a position consisting of all calls, or all puts, with the same expiration, in which one sells a near in-the-money strike and buys a multiple number of contracts in an out-of-the-money strike. The goal is to have as minimal an outlay or debit as possible, while achieving a high ratio of long option contracts to short.

A good rule of thumb is to buy three contracts for every one sold for even money. I tend to use back spreads on the put side as portfolio protection, or straight-out bearish bets.

Let's look at the basic construction of a back spread using our old friend Google (NASDAQ:GOOG), which has been sliding following its April 12 first-quarter earnings report.
No positions in stocks mentioned.

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