Lessons from the Pros

Options Article

Ratio Spread – Calls

We have been bombarded with questions about ratio spreads in class.  Let’s start out with explaining a Call Ratio Spread, though that is not the favored strategy.

A Ratio Spread is a combination of a larger quantity of short deep OTM options, and long OTM options at a different strike price.  The premium taken in for selling a larger quantity of short, deep OTM options occasionally is greater than the premium paid for the long OTM options, thus creating a credit.  But, typically an option trader of ratio spreads ends up with a small debit.  Multi-legged options have contract fees for each and every single leg, which can add up and eat away into any potential return. The goal is to select a broker that does not charge an outdated ticket fee on top of existing fees per option contract.  Option traders should look for the most economical way to trade when it comes to brokerage fees, commissions, and ticket charges.

Let us look in detail at a possible ratio spread: a call ratio spread.  This particular advanced option strategy is known at different brokerage houses by different names; for instance Ratio Vertical Spread with Calls, or Call Front Spread. Regardless of the different labels for the name, the spread is built with calls that are disproportionate in quantity and in the same expiration. Namely, there are more short calls at the higher strike than long calls at the lower strike.  If it was the other way around, then we have a completely different strategy which is known by a different name: Reverse Ratio (Call) Spread or simply Ratio Call Backspread. Perhaps in one of my future articles we will go over this, as well as the more practical version of this strategy, the put ratio.

Let us turn our attention to the composition of a Call Ratio Spread. The set up is done in such a way that we purchase a single contract at a lower strike price, and sell two contacts at a higher strike. To visualize it in our minds, think of a stock trading at 47 and the 50 level being a really strong level of resistance.  Buying an OTM Bull Call spread involving a long lower 49 strike price call and selling the higher 50 strike price call would closely match what this Call Ratio Spread is; with the one exception: an additional 50 call is sold so the extra premium can offset the cost of the 49 call.  The figure below gives a visual.

Stock at 47
STO – 2 June 50 (deep OTM) call @ 1.50
BTO + 1 June 49 (OTM) call @ 2.50

To figure out the net credit we need to multiply $1.50 by two contracts sold, bringing in $3 from which $2.50 must be subtracted.  The net credit is $0.50 per share or $50 per contract. This net credit should be viewed as a minimum profit.  The calculation for Maximum Profit is a bit more elaborate because it takes into consideration the strike price spread. The formula for Max P is the number of long contracts multiplied by the strike price difference plus the net credit. In our example, the number of 49 calls is only one, and the difference between the strike price spread is also one, while the credit per share is $0.50 so: 1 x (50c-49c) +$0.50 = 1 x $1.50 = $1.50

The maximum profit takes place at the expiry if both short 50 calls expire worthless, and the long call is closed for profit because it is in-the-money; specifically if XYZ was 49.99 at expiry.

Nevertheless, as attractive as the max profit seems, keep in mind that the selling of the two calls gives the obligation to sell the stock at the 50 strike price. Only one of those two sold calls is covered; the second sold 50 call is uncovered, exposing the trader to theoretically unlimited risk. If the price were to rally from 47 up and beyond 50, which abnormal moves do happen, then action needs to be taken. The goal was to see the stock price close below 50. Hence the stock could go slightly up, from 47 to 49.99, remain unchanged, or fall and the net premium received (0.50) stays the same. Any strong bullish move above 50 could result in losses.  Also, if a trader is not approved for trading uncovered calls then most likely this type of trade will get rejected by the broker even before it gets executed.

In conclusion, this article has given an XYZ example of a Call Ratio Spread. This advanced option strategy is not suitable for novice traders for it requires the approval for trading uncovered calls. One of the ways that the professionals utilize this strategy is by trading it with index options that are European style. Fluctuations in an index historically have been NOT as volatile as in individual stocks, especially pharmaceuticals.  Keep in mind that with options education, there is always another higher level to learn about.  One should never stop learning.

DISCLAIMER This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.

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