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Description and use

Ratio Call Spread strategy is the opposite of Call Ratio Backspread. The difference is that in this strategy, the Short Calls have higher strikes. Consequently, loss is going to be unlimited and profit is going to be limited. Because of the unlimited risk, increasing volatility is harmful for the position. This strategy is not recommended. Stagnating share prices make the situation better. The strategy consists of Short and Long Call options with the same expiration, but different quantities. Typically, the ratio of the sold/purchased Call options is 2:1 or 3:2. The potential loss is unlimited. The direction of the market is neutral/decreasing. The trader speculates on low volatility shares with stagnating prices. The profit is maximised when the share closes at the upper breakeven point. The investment should be short-term, maximum one month.

  • Type: Neutral, Bearish
  • Transaction type: Debit
  • Maximum profit: Limited
  • Maximum loss: Unlimited
  • Strategy: Ratio spread

Opening the position

Ratio Call Spread Option Position 1

Ratio Call Spread Option Position 1

or

Ratio Call Spread Option Position 2

Ratio Call Spread Option Position 2

  • Buy one or two lower strike Call options.
  • Sell two or three higher strike Call options.
  • The ratio of purchased/sold options should be 1:2 or 2:3.

Steps

Entry:

  • Make sure the trend is inclining.

Exit:

  • When the share price is above the Stop Loss, close the positions.
  • Close the positions at least one month before the expiry date.

Basic characteristics

Maximum loss: Unlimited.

Maximum profit: Difference between strike prices - Net credit (or + Net debit).

Time decay: Time usually has a positive effect on the value.

Lower breakeven point: Lower strike price + Net Credit / Quantity of Long options.

Upper breakeven point: Lower strike price + (Difference between strike prices * Short Call quantity) / (Short Call quantity - Long Call quantity) + Net Credit (or - Net debit).

Advantages and disadvantages

Advantages:

  • The investor can profit from share prices moving within given limits.

Disadvantages:

  • The loss is unlimited if the share prices increase.
  • Moving share prices cause further risks.
  • Complexity of the strategy.

Closing the position

Closing the position:

  • Buy back the Short options and sell the Long options.

Mitigation of losses:

  • Close the position the above-mentioned way.

Example

Ratio Call Spread strategy example

Ratio Call Spread strategy example

ABCD is traded for $25.37 on 25.05.2017. The investor buys a Long Call options which has a strike price of $25.00, expires in June 2017. and costs $3.11 (premium). Then, sells two Short Call options which have a strike price of $27.50, expire in June 2017. and cost $1.52 (premium).

Price of the underlying (share price): S= $27.65
Premium (Short Calls): SC= $1.52
Premium (Long Call): LC= $3.11
Strike price (Short Calls): KS= $27.50
Strike price (Long Call): KL= $25.00
Net debit: ND
Maximum loss: R
Maximum profit: Pr
Lower breakeven point: LBEP
Upper breakeven point: UBEP
Quantity (Long Call): nL= 1
Quantity (Short Calls): nS= 2

Net debit: ND = LC - 2 * SC
Maximum loss (risk): Unlimited
Maximum profit: Pr = (KS - KL) - ND
Lower breakeven point: UBEP = KL + R
Upper breakeven point: UBEP = KS + R

ND = $0.07
R = unlimited
Pr = $2.43
LBEP = $25.07
UBEP = $29.93