Short Bull Ratio Spread
The short bull ratio spread is an options trading strategy that is used to profit from a security increasing in price in a similar way to simply buying calls. Specifically, it's designed to reduce the upfront costs of taking such a position while still allowing for unlimited profits.
In some ways, it's straightforward to apply because it only requires two transactions, but there are some complexities involved, such as choosing an appropriate ratio and knowing which strike prices to use. Below, you will find a detailed explanation of exactly how it works.
The Key Points
- Bullish Strategy
- Not Suitable for Beginners
- Two Transactions (buy calls & write calls)
- Little to no upfront cost
- Medium Trading Level Required
- Also known as Short Ratio Bull Spread, Short Ratio Call Spread
Reasons for Using the Short Bull Ratio Spread
This strategy is best used when you are expecting a security to make a strong rise. It's very similar to the simple long call in that the potential for profits is unlimited; however, while it does not make quite the same level of returns as the long call, it significantly reduces the upfront costs. It's an ideal strategy to use if you are reasonably confident of a security going up, but have some concerns that it may fall in price and don’t want to invest too much capital upfront.
Implementing the Short Bull Ratio Spread
The short bull ratio spread requires two simultaneous transactions: buying calls (using the buy to open order) and writing calls (using the sell to open order) with a lower strike, but based on the same underlying security and with the same expiration date. You need to buy a greater number of options than you write, and the idea is to keep the upfront cost as low as possible by buying ones that are cheaper than those that you write.
The exact ratio of options bought to ones written is largely up to you, but a commonly used ratio is 3 to 1. It's also your decision as to which strikes to use, but generally you should look to buy options that are at the money and write ones that are just in the money.
How Profits Are Made
This strategy will return a profit if, by the time of expiration, the price of the underlying security rises sufficiently so that the price of the calls you own is high enough to make them worth more than the ones you have written, bearing in mind the ones you have written have a lower strike and a higher price.
As an example (assuming you have applied a 3 to 1 ratio), if the calls you own are worth $1 each and the ones you have written are worth $2.50 each, then you will be in profit. The higher the price of the underlying security goes up, the more profit you will make.
The maximum loss occurs when the price of the underlying security is equal to the strike of the calls bought at the time of expiration. This would mean the calls you own expire worthless, but you will have a liability on the ones you have written with the lower strike.
Unusually for a bullish strategy, you will actually be better off if the price of the underlying security falls dramatically then you will be if it only falls a little bit. If the price does drop far enough to be below the strike of the calls options, then they will expire worthless too and you will only lose any upfront cost you incurred. This is why you should try and make the upfront cost as close to zero as possible.
Pros & Cons
Perhaps the biggest advantage of this strategy is the fact that you technically have the best of both worlds. Providing the price of the underlying security goes up by at least a fair amount then there is no limit to the profits you can make, but you don’t stand to lose anything (or at least very little) if the price of the underlying security goes down by a fair amount.
The only risk is that the security doesn’t move much in price at all and you lose the money spent on the options bought, but you still have a liability on the ones written. The fact that you can implement the spread without any upfront cost is also obviously appealing.
The only major downside is that you do need to get the calculations right in terms of the ratio of the strikes for the strategy to work properly. This might seem simple enough once you know what you are doing, but it can be difficult when you are starting out. The other minor drawback is that you won’t make profits at quite the same rate as just buying options, but that's the trade-off for reducing the upfront costs.
Here we have provided an example of how a short bull ratio spread can be implemented and what the potential outcomes could be. Please note this is just a rough guide to how the strategy works, and it doesn't take into account commission costs. The options prices are hypothetical.
- Company X stock is trading at $50, and you expect a strong increase in price.
- At the money calls on Company X stock (strike price $50) are trading at $2 and in the money calls on Company X stock (strike price $45) are trading at $6.
- You buy 3 call contracts with a strike price of $50 (each contract containing 100 options) at a cost of $600. This is Leg A
- You write 1 call contract with a strike price of $45 (each contract containing 100 options) for a credit of $600. This is Leg B
- You have created a short bull ratio spread for zero upfront cost.
If Company X stock increases to $53 by expiration
The calls you have bought in Leg A will be worth around $3 each, for a total of $900. The ones you have written in Leg B will have a liability of around $8 each for a total of $800. You will have made a profit of approximately $100.
If Company X stock increases to $55 by expiration
The calls you have bought in Leg A will be worth approximately $5 each, with a total of $1,500. The ones you have written in Leg B will be worth approximately $10 each, and a total of $1,000. Your profit will be around $500.
If Company X stock remains at $50 by expiration.
The calls you have bought in Leg A will be at the money worthless. The ones you have written in Leg B will have a liability of around $5 each for a total of $500. You will have lost approximately $500.
If Company X stock falls to $45 by expiration.
The calls you have bought in Leg A will be worthless, and so will the ones you have written in Leg B. You will have roughly broken even on the trade.
The higher the price of Company X stock by expiration, the more profit you would make. If the stock fell any lower than $45, then nothing would change and you would be about break even.
Profit, Loss & Break-Even Calculations
- Maximum profit is unlimited.
- Profit made is “((Price of Underlying Security – Strike Price in Leg A) x Number of Options in Leg A) – ((Price of Underlying Security – Strike Price in Leg B) x Number of Options in Leg B).
- If you incurred a net debit when creating the spread, then that would have to be deducted from your profits.
- Maximum loss is limited
- Maximum loss is made when the “Price of Underlying Security = Strike Price of Leg A”
- Maximum loss is “(Price of Underlying Security - Strike Price in Leg B) x Number of Options in Leg B”
- If you incurred a net debit when creating the spread, then that would have to be added to your losses.
- The break-even points of the short bull ratio spread will depend on the ratio used, the upfront costs (if any) and the strike prices used. We would advise that you carry out your own calculations when applying the short bull ratio spread to determine where the break-even points are.
The short bull ratio spread has some clear advantages, and is certainly worth considering when you are confident that a security is going to increase significantly in price. Although the potentials profits are reduced compared to simply buying calls, there's still no upper limit to how much the strategy can make, and it can be applied for little or no cost.
There are some risks involved, of course, but these are low compared to the potential upside. However, it isn’t a strategy we would recommend for beginners because of the complexities of working out the best ratio to use and the optimal strikes.