Ratio Backspreads

[caption id="" align="alignright" width="300" caption="Image via Wikipedia"][/caption]

The market is down big over the past few days, partly in response to the Japanese disaster in Sendai, and also becuase this is a perfect opportunity to take profits from what has been a tremendous run.  We were stretched.  It was time for a breather, and breathers are generally good for the market.  Don't panic. 

In that vein, doing backspreads is probably not such a bad idea at this time, when some stocks have really taken a terrible drubbing.  To wit: ESRX has traded down over the past two days to $51.80 at close today.  If you still believe in the long-term fundamental story of ESRX, but wish to protect against further declines, you could create a ratio call backspread consisting of a Bear Call Spread and a Long Call.  Let's see how this works:

ESRX   $51.80

BTO  10x April 2011 57.5 call = ($0.26) = ($260)

STO 5x April 2011 55 call=$0.62=$310

Net Credit=$50

In this trade, you purchase twice as many long calls that are farther out of the money as you sold short calls.  You received a credit for this position.  Therefore, if ESRX continues to decline; or if it stays the same between now and April expiration; or rises just a bit, you would be "safe" with the nominal $50 credit.  The beauty of this spread is that, if ESRX has been taken down along with the entire market because of no bad news of its own, it can rally to the moon and you would make money becuase you have 5 long calls that are available to benefit from such a rally.  If, however, the stock declines, you are protected down to $0.  In truth, you protected yourself down to $54.50, below which there can be no more losses in this position, since you capped the downside.  But since you sold the 55 call, you sold someone the right to buy the stock from you at 55.  If the stock rallies, remember that you own the 57.5 calls.  If you're asleep at the wheel and do not monitor your position, the worst case scenario is that you will have your position exercised to the tune of $1,250 (55-57.5 calls) but you received $0.36 credit per spread on the 5x, which mitigates the "loss" to $2.14.  Your "loss" therefore would be $1,070.  The $57.5 long calls are in place in the event the stock rallies much higher.