THE CALL RATIO BACKSPREAD
The call ratio backspread is a dynamic options trading strategy that may also be viewed as a bullish approach. This strategy has the ability to capitalize on significant price fluctuations in a security, with unlimited profit potential in the event of an upward movement, and limited profit potential in the event of a downward movement.
While this spread involves only two transactions, it is not advisable for novice traders due to its complexity.
Important Considerations
Volatile Strategy
Not Suitable for Beginners
Two Transactions (buy call options and write call options)
Credit Spread (upfront credit received)
Medium Trading Level Required
Creation of the Call Ratio Backspread
Implementing a call ratio backspread involves two essential transactions: purchasing calls and writing calls. As a ratio spread, the quantity of options in each leg differs, with a requirement to buy two calls for every call written. The purchased calls should be at the money, while the written calls should be in the money.
While you have the flexibility to choose the strike for the written options, it is imperative to establish a credit spread, ensuring that the total credit from the written contracts exceeds the total debit from the purchased contracts. Both transactions should have the same expiration date.
For a clearer understanding of the process of creating a call ratio backspread, an illustrative example is presented below, accompanied by theoretical outcomes.
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.
Options with a strike price of $50 are currently trading at $2. You purchase 2 contracts, each containing 100 of these options, for a total cost of $400. This constitutes Leg A.
Options with a strike price of $46 are trading at $5. You sell 1 contract of these options, receiving a credit of $500. This forms Leg B.
A call ratio backspread has been established with a net credit of $100.
If the price of Company X stock remains at $50 upon expiration, the options purchased in Leg A will expire worthless, while those written in Leg B will be valued at approximately $4 each ($400 in total). The liability of $400 will be partially mitigated by the initial $100 net credit, resulting in a total loss of $300.
In the event that the price of Company X stock rises to $52 by expiration, the options purchased in Leg A will be valued at around $2 each ($400 total), whereas those written in Leg B will be valued at approximately $6 each ($600 total). The total liability of $600 will be offset by the $400 value of the owned options and the initial $100 net credit, resulting in a total loss of $100.
If the price of Company X stock increases to $55 upon expiration, the options purchased in Leg A will be valued at approximately $5 each ($1000 total), while those written in Leg B will be valued at around $9 each ($900 total). With a liability of $900, which is less than the $1000 value of the owned options, a profit of $100 will be realized in addition to the initial $100 net credit, resulting in a total profit of $200.
In the scenario where the price of Company X stock falls to $48 upon expiration, the options purchased in Leg A will be worthless, whereas those written in Leg B will be valued at around $2 each ($200 total). The liability of $200 will be partially offset by the $100 initial net credit, leading to a total loss of $100.
If the price of Company X stock drops to $45 upon expiration, all options in Leg A and Leg B will expire worthless, resulting in a profit equivalent to the $100 net credit initially received.
Executive Summary
The call ratio backspread presents a higher level of complexity compared to other trading strategies, requiring intricate calculations. Its primary advantage lies in the potential to achieve unlimited profits in the event of a significant rise in the underlying security's price, while still yielding a profit in the case of a substantial drop.
Furthermore, this strategy offers the advantage of limited potential losses, allowing for precise risk assessment. Under suitable conditions, this strategy merits consideration; however, it is not recommended for inexperienced traders.
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