Call Ratio Spread
The call ratio spread is a complex options trading strategy that isn't recommended for beginner or inexperienced traders. It's generally considered a neutral strategy, because it's typically used when the expectation is that the price of a security won't move by very much.
It can actually potentially return a profit in three different scenarios; if the price of the security goes up a little, goes down, or stays the same. This gives the spread a very good chance of returning a profit, and it can only lose money if the price of the security goes up substantially. Please see below for further details.
- Neutral Strategy
- Not Suitable for Beginners
- Two Transactions (buy calls and write calls)
- Credit Spread (upfront credit received)
- Medium/High Trading Level Required
When the Call Ratio Spread is Used
Although it's considered a neutral strategy, the call ratio spread is actually best used when you believe that a security will go up in price by a relatively small amount, because this is how it will return a greater profit. The great thing about it, though, is that you can even profit from it if the price of underlying security drops a little or stays the same.
This makes it an ideal strategy to use if you are confident that the price of security will increase by a small amount, but you want to try and profit if your forecast is wrong and the price in fact stays the same or drops. It shouldn't be used if you think there's a chance that the security will increase dramatically in price; this scenario will cost you money.
How the Call Ratio Spread is Created
The call ratio spread is, as the name suggests, a type of ratio spread, which means that the legs that are required involve unequal amount of options. This makes the strategy more complicated than a lot of the alternatives, and it's best avoided by beginners.
There are two legs involved, which would typically be transacted simultaneously. For one leg you should buy a number of in the money or at the money call options on the relevant underlying security, and for the other leg you should write a greater number of out of the money calls on the same underlying security. Your goal is to create a credit spread, where you receive a net credit at the time of establishing it.
You need to bear this in mind when considering what ratio, and what strikes to use. The ratio is the number of calls written compared to the number bought, and between 2 to 1 and 3 to 1 is fairly standard. When you are using the strategy for the first few times, it's probably a good idea to stick to a ratio around that level.
In terms of strikes, we would advise that buying at the money calls and writing calls at a slightly higher strike. Once you are familiar with the strategy and how it works, you can start adjusting the ratio and the strikes according to your objectives.
Below is an example of when and how you might create a call ratio spread. We have used hypothetical options prices rather than exact market data, just to provide a simple overview of how the spread can work. We have also ignored commission costs, again for the sake of simplicity.
- Company X stock is trading at $50, and you believe it will remain at around that price or possibly increase to $52, but no higher.
- Calls with a strike of $50 (i.e. at the money) are trading at $2. You buy 1 contract containing 100 of these options at a cost of $200. This is Leg A.
- Out of the money calls with a strike price of $52 are trading at $1. You write 3 contracts, each containing 100 of these options, for a credit of $300. This is Leg B.
- You have created a call ratio spread using a 3 to 1 ratio, for a net credit of $100.
Profit Potential & Risk of Loss
The maximum profit is made when the price of the security (Company X stock) is trading at a price equal to the strike of the calls in Leg B ($52 in this instance) at the time of expiration. This will result in the calls in Leg A expiring in in the money, while the ones in Leg B will expire at the money and worthless.
If the price of the underlying security rises above this level the position will start to reverse, and will turn into a losing position if the price goes too high. If the price of the underlying security stays the same price, or falls, the spread will still return a profit equal to the net credit received at the time of creating it. Let’s look at some possible outcomes.
- If the price of Company X stock stays at $50, or falls, then the calls in both legs will be worthless at expiration. You'll have no further returns and no further liabilities. Your profit will be the net credit received: $100.
- If the price of Company X stock is somewhere between $50 & $52 at expiration, then the calls options in Leg B will be worthless and you will have no further liabilities. The ones in Leg A will be in the money and worth something. Your profit will be the net credit plus the value of the options owned.
- If the price of Company X stock is at $55 at expiration, then the calls in Leg A will be worth $5 each, for a total value of $500. The ones in Leg B will be worth $3 each, for a total of $900. This loss of $400 is partially offset by the $100 initial net credit received for a total loss of $300. This loss would be greater if the price of the underlying security is any higher.
The following calculations can be used to determine how this strategy can profit, how it will return a loss and what those profits and losses might be.
- Maximum profit is made “Price of Underlying Security = Strike of Options in Leg B”
- Maximum profit is “((Strike of Options in Leg B – Strike Price of Options in Leg A) x Number of Options Bought in Leg A) + Net Credit Received”
- Profit is also made when “Price of Underlying Security = or < Strike of Options in Leg A)”
- Profit in the above scenario is the Net Credit Received.
- Profit is also made when “Price of Underlying Security > Strike of Options in Leg A and < Strike of Options in Leg B”
- Profit in the above scenario is “((Price of Underlying Security – Strike Price of Options in Leg A) x Number of Options Bought in Leg A) + Net Credit Received”
- A loss is made if the price of the underlying security rises to a point where “Value of Options in Leg B > (Value of Options in Leg A + Net Credit)”
- Losses will be “(Value of Options in Leg B – Value of Options in Leg A) – Net Credit”
This spread has one particularly clear advantage, in that it can profit if the price of the underlying security either falls or stays the same and it can profit from the underlying security going up. It will only return a loss if the price of the underlying security goes too high and the value of the options written increases above the value of the ones owned.
The downside is that it's a complicated strategy, and it can be difficult to calculate the optimal ratio to use and the best strikes to use.