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9 Weeks to Better Options Trading: Back Spreads

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Veteran options trader Steve Smith breaks down the back spread.

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The drawback with a back spread comes when there is a moderate decline that could lead to a very steep loss, especially if shares drift between the short and long strike prices -- the area I call the dead zone. The short strike could be in-the-money while the long options remain out, potentially becoming worthless, making back spreads a high-risk strategy.

Let's look at the worst-case scenario in the Google example above. If shares stabilized around the $625 level, and implied volatility continued the typical post-earnings decline, the position would be worth around a $7 net debit, for a $9 or 56% loss. If it were to be stubbornly held until the May expiration and shares were right at $600, the loss would be a whopping $32 -- far more than the initial $16 outflow.

This type of risk creates a dilemma: Back spreads can usually be established on a more attractive ratio closer to expiration as the further out-of-the-money option becomes less expensive. But holding a back spread until expiration increases the chances it will land in the dead zone and incur a loss.
No positions in stocks mentioned.

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