Call Ratio Backspread

When the Call Ratio Backspread is Used

As we have mentioned above, we have classified the call ratio backspread as a strategy for a volatile market. This means that we believe it's best used when you are expecting a significant movement in the price of the underlying security. However, while most volatile strategies are designed for when you aren't sure in which direction the price will move, this one is designed for when you believe the price will make a significant upward movement, but you also feel there's a chance it will make a significant downward movement.

This strategy will return a higher profit if the price of the underlying security rises substantially, but you can still make a small profit if it drops substantially.

How the Call Ratio Backspread is Created

There are two transactions required to create a call ratio backspread: buying calls and writing calls. Because it's a ratio spread, the amount of options in each leg aren't the same, and you need to buy two calls for every one written. The ones you buy should be at the money, while the ones you write should be in the money.

You can decide exactly what strike to use for the options you write, but you need to ensure that you create a credit spread (i.e. the total credit for the contracts written should be greater than the total debit for the contracts purchased). The expiration date for the contracts in both transactions should be the same.

To help clarify exactly how a call ratio backspread is created, we have provided an example below, along with some theoretical results.

Example of a Call Ratio Backspread

The example we have provided below uses hypothetical prices rather than real market data in order to keep the illustration easy to understand. For the same reason, we haven't included commission costs.

• Company X stock is trading at $50, and you believe the price will probably go up significantly but you also think that there's a chance it will go down.
• Calls with a strike of $50 are trading at $2. You buy 2 contracts (each containing 100 of these options) at a cost of $400. This is Leg A.
• Calls with a strike of $46 are trading at $5. You write 1 contract of these, for a credit of $500. This is Leg B.
• You have created a call ratio backspread for a net credit of $100.
• If the price of Company X stock remains at $50 by the time of expiration, then the options bought in Leg A will expire worthless, while the ones written in Leg B will be worth around $4 each ($400 total). Your liability of $400 will be partially offset by the $100 net credit initially received, and your total loss will be $300.
• If the price of Company X stock moves up to $52 by expiration, then the options bought in Leg A will be worth around $2 each ($400 total) while the ones written in Leg B will be worth around $6 each ($600 total). Your total liability of $600 will be partially offset by the $400 value of the options owned and the initial $100 net credit. Your total loss would be $100.
• If the price of Company X stock increases to $55 by expiration, then the options bought in Leg A will be worth around $5 each ($1000 total). The ones written in Leg B will be worth around $9 each ($900 in total). Your $900 liability is less than the $1000 value of the options owned, so you will make $100 in addition to the $100 initial net credit for a total profit of $200.
• If the price of Company X stock falls to $48 by expiration, then the options bought in Leg A will be worthless, while the ones written in Leg B will be worth around $2 each ($200 total). Your liability of $200 will be partially offset by the $100 initial net credit for a total loss of $100.
• If the price of Company X stock falls to $45 by expiration, then the options in Leg A and Leg B will all expire worthless. Your profit will be the $100 net credit initially received.

Calculating Profit, Loss & Break-Even Points

The call ratio backspread will return a profit providing the price of the underlying security makes a sizable movement in either direction. If it stays the same, or only moves a small amount, then you will make a loss. The maximum loss is limited though, so you know exactly what your risks are at the time of applying this strategy.

You can use the following calculations to determine the break-even points of the call ratio backspread and in what circumstances it will return a profit or a loss.

• A profit is made if “Price of Underlying Security > Upper Break-Even Point” or “Price of Underlying Security < Lower Break-Even Point”
• Upper Break-Even Point = “Strike of Leg A + (Strike of Leg A – Strike of Leg B) – (Total Net Credit / Number of Options Written in Leg B)”
• Lower Break-Even Point = “Strike of Leg B + (Total Net Credit / Number of Options Written in Leg B)”
• Maximum profit is unlimited if “Price of Underlying Security > Upper Break-Even point”. The higher the price of the underlying security goes the more profit is made.
• Maximum profit is limited to Total Net Credit if “Price of Underlying Security < Lower Break Even Point”.
• Maximum loss occurs when “Price of Underlying Security = Strike of Leg A”
• Maximum loss is limited to “((Strike of Leg A – Strike of Leg B) x Number of Options written in Leg B) – Total Net Credit”

Summary

The call ratio backspread is certainly more complicated than some of the alternative trading strategies, and some of the calculations involved are quite complex. Its main advantage, though, is that you can capture potentially unlimited profits if the price of the underlying security rises dramatically, while still making a profit if it drops significantly.

Another benefit is that the potential losses are limited, so you can calculate your exact risk exposure. In the right circumstances this is a strategy well worth considering, although we wouldn't advise inexperienced traders to use it.