Bull Ratio Spread

Why Use the Bull Ratio Spread?

The bull ratio spread is an excellent example of just how flexible options trading strategies can be. In general terms, you would use it if you are expecting the price of a security to increase in price and you have a fairly good idea of what price it will increase to, but it has other uses too.

It can also be used to reduce the upfront costs of speculating on an upward price movement of a security, and it can be used to create a situation where you can profit if the price of a security falls or stays the same price as well as profiting if it goes up. It can be applied in a number of different ways, depending on exactly what it is you are trying to achieve.

How to Apply a Bull Ratio Spread

The basics of the bull ratio spread are that you buy calls and also write calls with a higher strike price. However, it's not quite that simple. The strategy is known as a ratio spread, because the transactions involve a ratio of calls written to those bought i.e. you write a higher number than you buy. You can choose the exact ratio you use, depending on exactly what your objectives are. There are no hard and fast rules with this strategy, but if you are using this spread for the first time it's a good idea to keep it as straightforward as possible.

As a general rule, the simplest way to apply this spread is to buy at the money calls and write twice as many out of the money calls. You can, though, choose to write a higher ratio if you want. The benefit of writing more is that you will receive more money to offset the cost of the ones that you buy.

You can even write enough so that you receive an upfront credit. This has advantages in terms of how you can make a profit (more information provided below), but the flipside is that you stand to lose more if the underlying security rises above the strike price of the contracts you write.

You'll also need to choose what strike to use when writing the calls, and a good rule of thumb is to use the price that you expect the underlying security to rise to. You should bear in mind that the strike of the contracts you write affects the potential profitability of this strategy. The higher the strike, the more you can make from the price of the underlying security going up. However, calls with a higher strike price are cheaper so you will also receive less money from writing them.

Profit & Loss Potential

The primary way for the bull ratio spread to return a profit is if the underlying security goes up in price, but it's actually a little more complicated than that. Because the strategy involves writing more calls than you buy, if the price of the underlying security rises above the strike of the written contracts, your profits will start to diminish and you could even lose money if it goes high enough.

Therefore the maximum profit is made when the price of the underlying security is equal to the strike of the written contracts at the point of expiration. When this happens, the bought contracts will return a profit and the written contracts will expire worthless meaning you have no further liabilities.

If the ratio you have applied results in a debit spread (i.e. you spend more on buying than you receive for writing), then the bull ratio spread will lose money if the underlying security falls in price or stays stable. This is because all the options you have written will expire worthless, but so will the ones you have bought. You will therefore lose the difference between what you spent on buying and what you received for writing.

If the ratio you applied results in a credit spread (i.e. you receive more for writing than you spend on buying), then the bull ratio spread will return a profit if the underlying security falls in price or stays stable. Again, the options bought and the ones written will all expire worthless: leaving you with the net credit you received at the time of applying the strategy.

Advantages & Disadvantages

The biggest advantage of the bull ratio spread is really in the flexibility that it offers. You can adjust the ratio of the spread and the strike of the options involved to help you achieve whatever objectives you may have. You can greatly increase your potential profits when the underlying security goes up in price if you can accurately predict what price it will end up at by expiration. You can also limit the amount you lose if the underlying security fails to go up, or falls, in price. You can even turn that into a profitable outcome if you choose the appropriate ratio.

The main disadvantage is that it's a complex strategy to understand. Even though there are only two transactions involved, it can be difficult to calculate the optimum ratio and strikes to use. The flexibility offered is obviously a good thing, but the downside to this is that it can be confusing to know exactly how to apply the strategy. It also requires a high trading level, which may mean it isn't possible for a trader to use it.

Example

Below is one example of how the bull ratio spread can be applied and what the potential outcomes may be. Please note though, this is just a hypothetical example to provide a rough overview of how the strategy works and it doesn't use exact options prices. For the sake of simplicity, no commission charges have been included.

Initial Trade

• Company X stock is trading at $50, and you expect it to increase in price to around $54.
• At the money calls on Company X stock (strike price $50) are trading at $2 and out of the money calls on Company X stock (strike price $54) are trading at $.20.
• You buy 1 call options contract with a strike price of $50 (each contract contains 100 options) at a cost of $200. This is Leg A
• You write 2 call options contracts with a strike price of $54 (each contract contains 100 shares) for a credit of $40. This Leg B
• You have created a bull ratio spread for a net debit of $160.

If Company X stock does not go up in price, or falls, by expiration

The calls written in Leg B expire worthless, meaning you have no liabilities, but the ones bought in Leg A also expire worthless, meaning no returns. The $160 debit paid at the time of applying the strategy is lost.

If Company X stock goes up to $54 by expiration

The calls written in Leg B are at the money, and they expire worthless with no liabilities. However, the ones bought in Leg A are worth approximately $4 each, for a total of $400. Taking into account your initial investment of $160, you have made $240 profit in total.

If Company X stock goes up to $58 by expiration

The calls written in Leg B will be in the money at the expiration, and worth approximately $4 each. This would give you a total liability of around $800. The ones bought in Leg A will be worth around $8 each, and could be sold for a total of around $800. Your initial investment of $160 would be the net loss.

If Company X stock rose even further, then you would lose even more money. Although the calls owned would be worth more, so would the ones written. You have written twice as many of those, which means double the profit. You would be able to close your position at any time by simply selling the options in Leg A and buying back the ones in Leg B.

Profit, Loss & Break-Even Calculations

• Maximum profit is limited.
• Maximum profit is made when “Price of Underlying Security = Strike Price of Leg B”
• Maximum profit, per option owned, is “(Strike Price of Leg B – Strike Price of Leg A) – (Price of Option in Leg A – (Price of Option in Leg B x Ratio Used))”
• Ratio Used = “Number of Options in Leg B / Number of Options in Leg A”
• Loss is limited to the net debit if “Price of Underlying Security <= Strike Price of Leg A"
• Note, if a credit spread has been created instead of a debit spread, the spread will be in profit if “Price of Underlying Security <= Strike Price of Leg A"
• Loss is potentially unlimited if “Price of Underlying Security > Strike Price of Leg B”
• The amount of potential losses will depend on the ratio used, and whether a credit spread or debit spread has been created. We would suggest you carry out your own calculations when placing this spread to determine the potential losses.
• Break-even points will also depend on the ratio used and whether a credit spread or debit spread has been created.

Summary

This is a really powerful strategy if used correctly. It's a complicated strategy that involves working out an optimal ratio and the best strike prices to use and we wouldn’t advise that beginner options traders use it.

If you are a more experienced trader though, and if you are confident in your trading skills and your ability to forecast price movements, then you can certainly make decent money with this strategy.