IPO Insight

Ratio Call Spread

Ratio Call Spread

Table of Contents

Basics Concepts – Ratio Call Spread

Basics Concepts – Ratio Call Spread

Description – Ratio Call Spread

  • The Ratio Call Spread is the opposite of a Call Ratio Backspread in that we’re net short options.
  • Increasing volatility is harmful to this strategy because of our exposure to uncapped risk.
  • The best thing that can happen is that the stock doesn’t move at all.
  • The Ratio Call Spread involves buying and selling different numbers of the same expiration calls.
  • Typically we sell and buy calls in a ratio of 2:1 or 3:2, so we are always a net seller.
  • This gives us the uncapped risk potential. It also reduces the net
  • cost of doing the deal such that we create a net credit.
  • Buy one or two lower strike calls.
  • Sell two or three higher strike calls with the same expiration date.
  • The ratio of bought to sold calls must be 1:2 or 2:3.
  • You will be trying to execute this trade for a net credit.
Description – Ratio Call Spread

Steps to Trading a Ratio Call Spread

Steps In

  • Try to ensure that the trend is upward and identify a clear area of Resistance.

Steps Out

  • Manage your position according to the rules defined in your Trading Plan.
  • If the stock falls below your stop loss, then unravel the entire position.
  • In any event, look to unravel the trade at least one month before expiration, either to capture your profit or to contain your losses.

Context - Ratio Call Spread

Outlook

  • With Ratio Call Spreads, your outlook is neutral to bearish—you are looking for decreasing volatility with the stock price remaining range bound.

Rationale

  • To execute a neutral to bearish income trade for a net credit.
  • You are looking for the stock to remain below the upper breakeven point.

Net Position

  • You want to do this as a net credit to maximum your profit potential.
  • Your maximum risk on the trade itself is unlimited.
  • Your maximum reward on the trade is limited to the difference between the strike prices plus the net credit
    (all multiplied by the number of long contracts).

Effect of Time Decay

  • Time decay is generally helpful to your position
  • You want to be exposed to as little time as possible
  • You are exposed to unlimited risk here, so you do not want that exposure to last for long.

Time Period to Trade

  • You will be safer to choose a longer time to expiration

Breakeven Down = [Lower strike – (net debit/number of long contracts)]

Breakeven Up = [Lower strike price] + [difference between strikes * number of short contracts] / [number of short contracts – number of long contracts] + [net credit received] or – [net debit paid]

Exiting the Trade - Ratio Call Spread

Exiting the Position

  • With this strategy, you can simply unravel the spread by buying back the Calls you sold and selling the call options you bought in the first place.
  • Advanced traders may leg up and down or only partially unravel the spread as the underlying asset fluctuates up and down.

Mitigating a Loss

  • Unravel the trade as described previously.
  • Advanced traders may choose to only partially unravel the spread leg-by-leg and create alternative risk profiles.

Advantages and Disadvantages

Advantages

  • Net credit raised.
  • Profitable if the stock remains range bound.

Disadvantages

  • Uncapped risk if the stock price rises.
  • More risk if the stock moves.
  • Comparatively complicated trade for the intermediate trader.

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