DEFINITION of 'Call Ratio Backspread'

Call ratio backspread is a term used to describe a very bullish investment strategy that combines purchases and sales of options to create a spread with limited loss potential and mixed profit potential. Traders use call backspread strategies when they expect the price of the underlying to rise. Gains can be significant if the underlying financial instrument rallies.

BREAKING DOWN 'Call Ratio Backspread'

Backspread strategies are designed to benefit from trend reversals, or changes in recent market dynamics.

How Does a Call Backspread Strategy Work?

Call ratio backspread strategies are part of a category of options trading called ratio strategies. They are called “backspread” because with these types of trades a greater number of contracts are written on the long side of the trade. 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.

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.

Using Call Ratio Backspread Strategies

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, but reverse strategy to the call ratio back spread 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.

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