What Is a Call Ratio Backspread?
A call ratio backspread is an option strategy that bullish investors use if they believe the underlying security or stock will rise by a significant amount.
The strategy combines the purchases and sales of options to create a spread with limited loss potential and mixed profit potential. However, gains can be significant if the underlying financial instrument rallies.
How to Formulate a Call Ratio Backspread
A call ratio backspread is generally created by selling, or writing, one call option and then using the collected premium to purchase a greater number of call options with the same expiration at a higher strike price. This strategy has potentially unlimited upside profit because the trader is holding more long call options than short ones.
For review, a call option gives the option buyer the right, but not the obligation, to buy a stock at a specified price within a specific time period. If an investor buys a call option with a strike price of $10 while the stock is trading at $10, the option is considered at-the-money. If the stock rises to $15, the call option makes money. If the underlying stock falls to $5, the investor loses only the premium paid for the call option and never owns the stock.
The call ratio backspread allows an investor to buy call options on a stock that is out-of-the-money meaning the option strike price is higher than the current stock price. So, if a stock was trading $15 in the market, an investor might buy call options with a $17 strike price and pays a premium for the options. The investor could also buy the call options at-the-money meaning the strike price of the options is equal to the current market price of the stock.
In order to finance the premium for purchasing the call options, the investor sells a call option that's in-the-money or below the current stock price. So an investor might sell one call option at a strike price of $13 while the current price of the stock trades at $15 in the market. By selling the call option, the investor gets paid a credit for the premium of the option. The credit offsets the premium paid for buying the call options at the $17 strike price. The offset in premiums could be a partial offset or the credit received could exceed the premium paid for the call options. The premiums charged depend on many factors including the volatility of the stock price.
What Does a Call Ratio Backspread Tell You?
Backspread strategies are designed to benefit from trend reversals or significant changes or moves in the market. Call ratio backspread strategies are part of a category of options trading called ratio strategies.
The goal of the strategy is to own call options on a stock because the investor believes the stock will go above the strike price of the purchased call options. Ideally, the price needs to go high enough to compensate for any premium paid for the call options. However, the sale of the option that's in-the-money is placed to pay the investor a credit to offset or finance the purchase of the call options.
Using the numbers earlier, the investor would want the stock price to rise from $15 to well above the $17 (the strike price for the call options) and earn enough to more than pay for any premium for purchasing the call options.
An investor using a call ratio backspread investing strategy would sell fewer calls at a low strike price and buy more calls at a high strike price. The most common ratios used in this strategy are one in-the-money short call combined with two out-of-the-money long calls or two out-of-the-money short calls combined with three in-the-money long calls. If this strategy is established at a credit, the trader stands to make a small gain if the price of the underlying security decreases dramatically.
Call ratio back spread strategies are designed to benefit from increases in market volatility. Investors typically employ them when they believe financial markets are poised to move higher. By simultaneously buying and selling call options, traders can hedge their downside risk, while benefiting from the upside as markets gain. Backspread strategies can be used on a standalone basis, to “go long” the market. Alternatively, they can be used as part of a larger or more complex investing position.
Options traders can deploy directional strategies such as ratio strategies to reflect either bullish or bearish views on the market. If that view is negative, there is a similar strategy to the call ratio backspread that is designed to benefit from falling markets. Known as put backspread strategies, these involve buying and selling combinations of put options rather than call options.Takeaways
- The call ratio backspread is an option strategy that bullish investors use if they believe the underlying security or stock will rise by a significant amount.
- The strategy combines the purchases and sales of options to create a spread with limited loss potential and mixed profit potential. However, gains can be significant if the underlying financial instrument rallies.
- The stock price has to move high enough whereby you make enough money on the two at-the-money call options you purchased combined with the initial credit to more than offset any loss from the one in-the-money option that you initially sold.
Example of a Call Ratio Backspread
The example below does not factor any commissions from a broker, which need to be considered before executing any strategy. Let's say you're an investor who's bullish on the stock of XYZ Company and you believe the stock could rise significantly in the short term.
- XYZ Company stock is trading at $20 per share in the market currently.
- Call options with a strike price of $20 (at-the-money) currently trade with a premium of $2 each. You buy two option contracts whereby each contract is 100 options for a cost of $400 in total.
- The second leg of the strategy involves you selling one in-the-money call option. Call options for a strike price of $16 are currently trading at $6 each. You sell one call option at a strike price of $16 and receive a credit for $600 to your account.
- You have a net credit of $200 for the strategy initially because you paid $400 for buying the two at-the-money call options while you received $600 for selling the one in-the-money option.
- If the stock rises to $22 by expiry, you earn $2 on the two call options you purchased for a total of $400 (or 2 contracts at 100 options each multiplied by $2).
- However, the call option you sold will get exercised, and you'll sell the stock at $16 while the market is at $22 for a $6 loss. The $6 is multiplied by 100 contracts (the one call option) yielding a $600 loss.
- Your net is the $600 loss minus the $400 you earned plus the $200 credit that you received initially for a gain of zero or breakeven.
In the above example, the stock price has to move high enough whereby you make enough money on the two at-the-money call options combined with the initial credit to more than offset any loss from the one in-the-money option that you initially sold.
Let's say in the example; the stock moved to $26 by expiry.
- You would earn $6 on the two call options for a total of $1,200 (200 multiplied by $6).
- The call option that you sold would have a loss of $10 ($16 strike - $26) or $1,000 because $6 multiplied by the 100 contracts would yield a loss of $1,000 for the one option sold.
- However, your net gain would be $400 because your $1,000 loss is subtracted from your $1,200 gain on the two options purchased plus the $200 earned from the initial credit.
Let's say in the example; the stock moved to $10 by expiry.
- The two options that you bought would expire worthless since you wouldn't exercise the option to buy at $20 when the price is trading at $10 in the market.
- Similarly, the call option that you sold would not get exercised because no one would buy at $16 if they can buy the stock at $10 in the market.
- In short, you would earn the initial credit of $200 and both options would expire worthless.
What's the Difference Between the Call Ratio Backspread and the Put Ratio Backspread?
A put ratio backspread is an options trading strategy that combines short puts and long puts to create a position whose profit and loss potential depends on the ratio of these puts. A put ratio backspread is so called because it seeks to profit from the volatility of the underlying stock, and combines short and long puts in a certain ratio at the discretion of the options investor.
The put ratio spread is similar to call ratio spread, but instead of buying two call options and selling one call option to finance the strategy, you would buy two put options and sell one put option to help finance the purchase of the two puts.
If the stock goes down by a significant amount, the strategy earns money from the two puts to offset any loss from the one put that was sold.
Limitations of Using the Call Ratio Backspread
As with any trading strategy, there is always the risk of loss due to market conditions or excessive volatility. It's best to contact your broker to get options training before initiating any strategy. Your broker should also have the ability to run test strategies in a mock account so you can get some experience before using real money.