dr_sean Trader Feedback: 0 Options Strategist
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Sometimes you’ll be watching a stock that you’re just waiting to see a break of the current trend. Whether you want it to break past previous highs—an official breakout —or fall under key support—a breakdown —there is way to trade this chart other than simply going long on the security, be it in the form of stock or calls.

Further, a lot of times—in the case of highly watched securities, indexes, or commodities—the trading pits will push the pps into uncharted territory, only to sell heavily into the breakout (or buy heavily into the breakdown) and cause a fakeout breakout.

Look at the 6 month chart for gold: XAU is a good one to see:

I got whipsawed out of my underwear in September . Even the best traders thought we had solid confirmation on that one:

So, at all times, by all means, beware of the fakeout breakout! (or fakeout breakdown).

Moral of this story is breakouts can actually turn out in high volalitility contrary movement.

Had I gone w. a Ratio Backspread, using a credit, I would have made money as the metals fell to pieces.

How can you play for a breakout with some protection? I tell you:

Ratio backspreading is an excellent options strategy to implement for someone playing a chart breakout.

How do you go about doing this?

-Sell 1 ITM call for a credit.

-Take that credit and turn around and use (almost or all of) it to buy calls at the next strike (normally, OTM).

Let’s say you set it up so you come out w. a net credit:

e.g, you sell 10 XYZ in the money call for $5.00

you then take that $5000 and use it to buy 40 XYZ out of the money calls for $1.00 each.

Your net credit is $1000.00 (the credit received from the ITM sale, $5000, less the debit used to purchase the 40 OTM calls, $4000).

So, how will your position work here?

You’d like the underlying to increase in value: in fact, your profit potential is unlimited.

However, should the stock show us a fakeout breakout and fall precipitously—say, below the strike price of that ITM call which you sold, you would be hedged: while your OTM calls would go to 0 ultimately, you’d receive the credit from the sale of the ITM call.

In the example we just made: you’d make $1000, the net credit, if XYZ was anywhere below the ITM strike price at Options Expiration.

The chart for your profit / loss would look like this:

Also, this Ratio Backspread strategy hedges you against volatility changes—if volatility drains, your OTM calls will drain, but so will the ITM calls you wrote. A great hedge to have—especially in highly anticipated breakouts.

Real example:

Let’s say you like LVLT for a break of $6.10. A lot of people are watching this one w. all the recent Youtube talk & speculation of LVLT coming into play w. their fiber-optic wiring. Lots of talk of LVLT at $10 by late next yr.

That’d be a nice move. IMO, the break of $6.10 is the entry. It is key. But this looks like a great example in which the MMs and powers that be run this thing to $6.20 or so, only to drain it back to 1987 .

LVLT current price = 5.66

Let’s say, for clarification, I enter right now, even though this is all because I’m anticipating the break of $6.10 (breakout)

LVLT daily

%img src=http://www.marketwatch.com/charts/int-adv.chart?symb=LVLT&sid=102815&time=7&startdate=&enddate=&freq=1&comp=&compidx=aaaaa

0&uf=0&ma=1&maval=50&type=4&size=3&lf=1&lf2=0&lf3=0&style=350&mocktick=1&rand=32157540 /%

LVLT annotated

Let’s say—as I suggested—the target is $10.00

Here’s my move:

Sell 10 LVLT June 2007 $5 calls @ $1.15 each (gross credit = $1150)

Buy 30 LVLT June 2007 $7.5 calls @ $.35 each (gross debit = $1050)

So my net cost of the position is ($100.00) in this instance. (i.e, $100 credit)

My maximum loss is if LVLT stays above $5, but does not move hard enough for the change in my $7.5 calls to offset the change in the $5 calls.

You can calculate your maximum loss in this instance.

You would do this looking at greeks and doing some long hand. OR, you could go to optionsxpress.com and sign up (free) or cboe.com and use the trading calculators.