RATIO CALL SPREAD
Strategy Type: Bullish
# of legs : 3 (Short 1 Lower Strike Call + Long 2 Higher Strike Calls)
Maximum Upside Reward : Unlimited, once the underlying crosses above the upper breakeven point
Maximum Downside Reward : Limited to the extent of Net Premium Received
Maximum Risk : Higher Strike Price - Lower Strike Price - Net Premium Received
Upper Breakeven Price : Higher Strike Price + Difference between Higher and Lower Strike - Net Premium Received
Lower Breakeven Price : Lower Strike Price + Net Premium Received
Payoff Calculation : Payoff of Short Call+ (2 * Payoff of Long Call)
In the above table, we have assumed the traditional 2:1 ratio wherein the trader is buying 2 Calls and selling 1 Call. However, note that this strategy can be executed using other combinations as well, such as buying 3 Calls and selling 2 Calls, buying 4 Calls and selling 2 Calls, buying 6 Calls and selling 4 Calls etc. The most commonly used long-short ratio to trade this strategy is 2:1 followed by 3:2. For our discussion henceforth, we will assume a total of 3 legs i.e. 1 Call short at a lower strike and 2 Calls long at a higher strike.
Explanation of the Strategy
A Ratio Call Backspread is a strategy that involves selling a lower strike Call option and buying 2 higher strike Call options having the same strike price, same expiration, and same underlying instrument. The lower strike Call that is sold is usually an ATM or an ITM option, while the higher strike Calls that are bought are OTM options. As the number of Calls bought are greater than the number of Calls sold, this is a bullish strategy. Usually, this strategy is a net credit strategy, although sometimes it can be a net debit strategy as well. For our discussion, we will consider this to be a net credit strategy. This strategy has two breakeven points: lower and upper. The strategy is profitable when the underlying price is either below the lower breakeven point or above the upper breakeven point and is unprofitable when the underlying price is in between the two breakeven points. Meanwhile, this strategy has limited risk. Maximum loss under this strategy occurs when the underlying price is exactly at the higher strike price. This is because at this level, both the long Calls are ATM and hence are worthless, whereas the short Call is in a loss-making position as it is ITM.
There are two ways to profit from this strategy: profit on the downside and profit on the upside. On the downside, the trader benefits when the underlying price is below the lower strike price i.e. below the strike price of the short Call. If this happens, the trader will get to keep the entire premium that he/she has received upfront. The trader would also profit if the underlying price is above the lower strike but below the lower breakeven point, although in this case the trader’s profit potential will be reduced. Meanwhile, on the upside, the trader benefits if the underlying price rises above the upper breakeven price. Because the trader is long two Calls as opposed to being short one Call, the profit potential is unlimited once the underlying price moves above the upper breakeven point. Given that the downside profits are quite limited while the upside profits are potentially unlimited, a trader who initiates this strategy would want the underlying price to rise sharply and surge past the upper breakeven point rather than stay below the lower strike price.
Remember, more often than not, this strategy is a net credit strategy, meaning the premium received on shorting the Call is greater than the combined premium paid on buying the two Calls. In fact, this is one of the few strategies that usually has a net credit profile and an unlimited upside potential in case the price rallies sharply. In other words, without making an upfront payment, the trader would have the opportunity to earn unlimited profits on the upside. Hence, from a risk to reward perspective, this strategy is highly attractive. That said, remember that this is a bullish strategy and must be implemented only when one has a strong bullish bias on the underlying. While the trader won’t lose money in case the underlying price falls below the lower strike price, any stagnation in the underlying price between the two breakeven points would cause the trader to suffer losses. So, having a strong conviction that the underlying price will rally sharply is necessary before initiating this strategy.
Benefits of the Strategy
· More often than not, this is a net credit strategy that requires no upfront payment
· This strategy can profit from a down move in price as well
· This strategy has an unlimited profit potential in case the underlying rallies sharply
· This strategy is subject to limited risk
Drawbacks of the Strategy
· Because this is a volatility-based strategy, stagnating underlying price can lead to losses
· Because this strategy involves selling an option, it will require a greater margin in your trading account
· Ensure that the trend is bullish and that you have a conviction that the underlying price will rally sharply going forward
· Keep in mind that the number of Calls bought must exceed the number of Calls sold. The ideal long-short ratio for this strategy is 2:1 and to some extent even 3:2
· When choosing strikes, don’t just randomly select any strike. Remember, you want the underlying price to rise beyond the upper breakeven point, so select strikes accordingly and realistically
· The difference between the lower strike and the higher strike will be a trade-off between net credit and risk
· The wider the difference between the two strikes, the larger would the net credit be but so would be the risk, and vice versa. This is because the wider the difference, the farther will the upper breakeven point be, meaning the larger will be the loss-making zone
· Because this strategy benefits the most when the underlying price rallies sharply, ensure that the underlying instrument being chosen for this strategy is exhibiting volatility
· Because you have more long Calls than short Calls, Theta will work against you, especially as the underlying price starts rising and inches closer towards the strike of the long Calls
· Because you have a greater number of long Calls than short Calls and because you want the underlying price to rise sharply, give yourself sufficient time to go right by selecting options that have ample life left
· Ensure there is sufficient liquidity in the underlying that is being chosen to initiate this strategy
Option Greeks for Ratio Call Backspread
At the time of strategy initiation, the sign of Greeks can vary depending upon the distance between the strike price of a short Call (lower strike) and those of the two long Calls (higher strike). Hence, we shall be talking about Greeks in general without discussing about the sign of each Greek at initiation.
GreekNotes : Delta : Delta is usually negative at initiation, meaning a fall in the underlying price will benefit the option position. However, if the underlying price rises and moves above the lower breakeven point, Delta will start turning positive, which means a rise in the underlying price will now start benefiting the option position, and vice versa.
Gamma: Gamma is initially negligible or slightly negative when the underlying price is at or near the lower strike. It starts rising as the underlying price rises and moves away from the lower strike. This causes the Delta to turn positive and move higher. Gamma peaks out near the higher strike and starts tapering after that. As a result, once the underlying movesabove the higher strike, Delta continues rising but at a slower rate as it approaches its upper extreme.
Vega : When the underlying price is below the lower breakeven point, Vega is negative because of which rising volatility hurts the position, and vice versa. However, when the underlying price moves above the lower breakeven point, Vega turns positive because of which rising volatility starts benefiting the position, and vice versa. Vega tends to peak out near the higher strike, above which it starts declining, meaning the impact of volatility on the position will start reducing once the underlying rises above the higher strike.
Theta : When the underlying price is below the lower breakeven point, Theta is positive because of which time decay benefits the position. However, when the underlying price rises above the lower breakeven point, Theta turns negative because of which time decay starts hurting the position. Theta bottoms out near the higher strike, meaning it is at this point where the negative impact of time decay is the highest. Once the underlying rises above the higher strike, the two long Calls become ITM, because of which the impact of Theta gradually starts tapering.
Rho : As this strategy involves buying two Calls as opposed to writing one Call, Rho turns positive as the underlying price rises and approaches the higher strike. As a result, rising interest rates can benefit the option position at higher levels. That said, this is the least significant of the Greeks, especially in case of short-dated options.
Payoff of Ratio Call Backspread
The chart below shows the payoff of the Ratio Call Backspread strategy. Observe that the strategy benefits both on the downside and on the upside. See that maximum profit potential on the downside is limited to the extent of the net premium received, and it occurs when the underlying price is below the lower strike. Similarly, see that the maximum profit potential on the upside is unlimited, and it occurs when the underlying price rises above the upper breakeven point. Also observe that in between the two breakeven points, the trader incurs a loss, with maximum loss occurring exactly at the higher strike price.
Example of Ratio Call Backspread
Let us say that Mr. ABC is very bullish on the short-term outlook of Nifty, based on which he has decided to initiate a Ratio Call Backspread strategy, wherein he will sell 1 ITM 9000 Call at ₹430 and buy 2 OTM 9500 Calls at ₹190 each. Let us summarize the details of the strategy below:
Strike price of shortCall = 9000
Strike price of longCall = 9500
Quantity of Calls sold = 1 lot
Quantity of Calls bought = 2 lots
ShortCall premium (lower strike) = ₹430
Long Call premium (higher strike) = ₹190
Net Credit = ₹50 (430 - 2 * 190)
Net Credit (in value terms) = ₹3,750 (50 * 75)
Lower breakeven point = 9050 (9000 + 50)
Upper breakeven point = 9950 (9500 + 500 - 50)
Maximum downside reward = ₹3,750
Maximum upside reward = unlimited
Maximum risk = ₹33,750 ((9500 - 9000 - 50) * 75)