Buying and selling call options together makes up the bullish options trading technique called the “call ratio backspread”. The strategy’s goal is to make the most profits, possible in the near future from a sizable increase in the underlying stock’s price. There is a theoretically infinite profit potential. The combination of purchased and sold options reduces risk.
The call ratio back spread strategy benefits from more price volatility in the underlying stock, which should help maximise returns. The term “ratio” in the name of the option strategy denotes the use of a 2:1 ratio of bought call options to sold call options. It is frequently used with longer-term or “back-month” options. They give the trade more time to work in the investor’s favour. So, it is known as a “back spread.”
So, if you know what are options trading, you might want to use this strategy. Let’s now see how to implement it.
Employing the Call Ratio Back Spread
The following is the methodology for implementing the call ratio back spread strategy:
- You write or sell a call option with a lower strike price.
- You purchase two options with higher strike prices.
Every option, whether purchased or sold, needs to have the same expiration date. If there is a net credit from the deal, it means that the proceeds from the sale of the single call option with a lower strike price were more than the costs of the two call options with higher strikes prices.
The exact option strike prices, the distance between the option strike prices, the volatility of the option prices, and the amount of time till the options expire will all determine whether the trade is executed with a net credit or net negative.
Profit Potential
Since the strategy involves a net long call position due to the acquisition of two call options, the potential profit from an increase in the underlying stock price is potentially infinite.
If you are able to set up this call spread position for a net credit, you may be able to make money even if the underlying stock price declines. All of the options will expire worthless, but you will keep the credit you were given when the position was constructed. This is because the stock price at the time of expiration is lower than the strike price of the sold call option.
When the position is set up at a net debit, there is no possible benefit from a downward move. However, the maximum loss is limited to the amount of the net debit incurred when the strategy was put in place.
Maximum Risk
If the underlying asset’s price is at the higher strike price of the two calls during expiration, you will incur the maximum loss. At that time, the maximum loss will be the difference between the call strike prices that were bought and sold. It would be minus the net credit earned or plus the net debit during taking the position.
Example
When a trader uses the call ratio back spread strategy, they buy two call options at Rs. 33 and sell one call option at Rs. 28. Let’s assume that the underlying stock is trading at Rs. 30 per share. The trader may witness any of the following four scenarios:
- Maximum Loss: The Rs. 28 strike price call that was sold is in-the-money (ITM), with an intrinsic value of Rs. 400 for the option buyer, but both of the Rs. 33 strike price calls that were acquired would expire worthless if the underlying stock is trading at Rs. 33 per share when the options expire. As a result, the trader using the call ratio back spread strategy will have to pay Rs. 400 to exit the position.
- Breakeven: If the underlying stock is trading at Rs. 40 a share at the time the options expire, there will be a Rs. 370 loss from the sold call. However, since both purchased calls are out-of-the-money (OTM) at expiry, they expire worthless. Therefore, the profit from these calls is Rs. 0.
- Maximum Profit: When the price of the underlying stock surpasses Rs. 28 per share, the call ratio back spread maximises profit. Past this threshold, the intrinsic value of the two purchased calls will exceed the intrinsic value loss from the call with the lower strike price that was sold.
- All of the options expire worthless if the underlying stock price drops to less than Rs. 28 per share by the time of expiration. Whether the trader makes a tiny profit or loses a small amount depends on whether the call spread was executed with a net credit or net debit.
Conclusion
Purchasing call options and selling a different quantity of call options on the same instrument and expiration date is a call ratio back spread. Some traders choose to employ the call ratio backspread as a bullish strategy rather than purchasing calls. The ability to start the transaction for a credit makes this technique more appealing to certain investors than purchasing long calls. You can also trade with platforms of brokerage firms like Share India. They offer the best demat account app, that comes will all the essential trading tools. The trade consists of an out-of-the-money long call spread combined with a bear call spread. When the implied volatility rises or the stock rises above the long call’s strike price, the approach is lucrative.