Bull Call Ratio Backspread
Call Ratio Backspread
- Bull Call Ratio Backspread
- Bull Call Ratio Backspread Profit, Loss, & Breakeven
- Bull Call Ratio Backspread vs Buying a Call
A Bull Call Ratio Backspread is a bullish strategy and is potentially an alternative to simply buying call options. There are two components to the call ratio backspread:
- Sell one (or two) at-the-money or out-of-the money calls
- Buy two (or three) call options that are further away from the money than the call that was sold.
Call Ratio Backspread Expectations
The ratio backspread is called such because there is a ratio of sold options to purchased option usually in the ratio of 1 sold to 2 purchased, or 2 sold to 3 purchased. A trader would use a Bull Call Ratio Backspread in the following hypothetical situation:
- A trader is very bullish on a particular stock trading at $50.
- The trader is either risk-averse, wanting to know before hand their maximum loss or wants greater leverage than simply owning stock.
- The trader expects the stock to move above $54.67 or not move at all or even fall in the next 30 days. However, a move higher to only $52.50 would prove disasterous for the trade.
Given those expectations, the trader selects the $52.50 call option strike price to buy two calls which are trading for $0.60 each so the total cost will be $120 (2 contracts x $0.60 x 100 shares/contract).
Also, the trader will sell one the at-the money call strike price at $50.00. By selling this call, the trader will receive $153 ($1.53 x 100 shares/contract). The net effect of this transaction is that the trader will receive $33 ($153 received - $120 paid).
Call Ratio Backspreads require Extreme Bullishness
For this trade, a trader must be extremely bullish on the stock. Only being slightly bullish will not work for this trade. One of the strange aspects of a bull call ratio backspread like the one in this example is that the greatest loss occurs in the direction the trader is hoping the trade will move (i.e. upwards).
The greatest loss occurs at the strike price of the purchased call options. The reason for this is that at $52.50, at expiration, the calls the trader purchased expire worthless ($120 loss). Meanwhile, the one call the trader sold has gained value and would be worth $250. The trader sold the call option for $153, so the sold call option has accrued a loss of $97 ($153 - $250). Combined with the loss suffered from the purchased options that expired worthless, the total loss is $217 ($120 + $97). The profit/loss graph on the next page illustrates this.
Once the stock price surpasses the strike price of the purchased calls (i.e. point of max loss), then the losses begin to decrease and eventually a profit occurs. This is because at the point of max loss, one call option that was purchased effectively begins to neutralize the option that was sold. One of the purchased option cancels out the movement of the one sold option. From there, the one remaining purchased option is free to begin to make a profit, just like if the trader only purchased a call option. In order to more clearly understand this past paragraph, the concept of delta must be understood.
Possible to make money if stock goes down
Yet another odd aspect of the bull call ratio backspread is that sometimes the trade will make money if the stock moves in the exact opposite direction the trader is expecting (i.e. downward). For instance, if the stock moves nowhere for 30 days and remains at $50.00, then the two calls the trader purchased would expire worthless ($120 loss). However, the one call the trader sold expired worthless also. Remember, the trader sold the option for $153; therefore, the trader actually gained on the transaction $33 ($153 gain - $120 loss).
The profit/loss graph for the bull call ratio backspread is given on the next page.
Next Page - Bull Call Ratio Backspread Profit & Loss Graph