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Call Ratio Spread

The call ratio spread is a complex options trading strategy that isn’t recommended for beginner or inexperienced traders. It’s generally considered a neutral strategy, because it’s typically used when the expectation is that the price of a security won’t move by very much.

It can actually potentially return a profit in three different scenarios; if the price of the security goes up a little, goes down, or stays the same. This gives the spread a very good chance of returning a profit, and it can only lose money if the price of the security goes up substantially. Please see below for further details.

Key Points

  • Neutral Strategy
  • Not Suitable for Beginners
  • Two Transactions (buy calls and write calls)
  • Credit Spread (upfront credit received)
  • Medium/High Trading Level Required

When the Call Ratio Spread is Used

Although it’s considered a neutral strategy, the call ratio spread is actually best used when you believe that a security will go up in price by a relatively small amount, because this is how it will return a greater profit. The great thing about it, though, is that you can even profit from it if the price of underlying security drops a little or stays the same.

This makes it an ideal strategy to use if you are confident that the price of security will increase by a small amount, but you want to try and profit if your forecast is wrong and the price in fact stays the same or drops. It shouldn’t be used if you think there’s a chance that the security will increase dramatically in price; this scenario will cost you money.

How the Call Ratio Spread is Created

The call ratio spread is, as the name suggests, a type of ratio spread, which means that the legs that are required involve unequal amount of options. This makes the strategy more complicated than a lot of the alternatives, and it’s best avoided by beginners.

There are two legs involved, which would typically be transacted simultaneously. For one leg you should buy a number of in the money or at the money call options on the relevant underlying security, and for the other leg you should write a greater number of out of the money calls on the same underlying security. Your goal is to create a credit spread, where you receive a net credit at the time of establishing it.

You need to bear this in mind when considering what ratio, and what strikes to use. The ratio is the number of calls written compared to the number bought, and between 2 to 1 and 3 to 1 is fairly standard. When you are using the strategy for the first few times, it’s probably a good idea to stick to a ratio around that level.

In terms of strikes, we would advise that buying at the money calls and writing calls at a slightly higher strike. Once you are familiar with the strategy and how it works, you can start adjusting the ratio and the strikes according to your objectives.

Below is an example of when and how you might create a call ratio spread. We have used hypothetical options prices rather than exact market data, just to provide a simple overview of how the spread can work. We have also ignored commission costs, again for the sake of simplicity.

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  • Company X stock is trading at $50, and you believe it will remain at around that price or possibly increase to $52, but no higher.
  • Calls with a strike of $50 (i.e. at the money) are trading at $2. You buy 1 contract containing 100 of these options at a cost of $200. This is Leg A.
  • Out of the money calls with a strike price of $52 are trading at $1. You write 3 contracts, each containing 100 of these options, for a credit of $300. This is Leg B.
  • You have created a call ratio spread using a 3 to 1 ratio, for a net credit of $100.

Profit Potential & Risk of Loss

The maximum profit is made when the price of the security (Company X stock) is trading at a price equal to the strike of the calls in Leg B ($52 in this instance) at the time of expiration. This will result in the calls in Leg A expiring in in the money, while the ones in Leg B will expire at the money and worthless.

If the price of the underlying security rises above this level the position will start to reverse, and will turn into a losing position if the price goes too high. If the price of the underlying security stays the same price, or falls, the spread will still return a profit equal to the net credit received at the time of creating it. Let’s look at some possible outcomes.

  • If the price of Company X stock stays at $50, or falls, then the calls in both legs will be worthless at expiration. You’ll have no further returns and no further liabilities. Your profit will be the net credit received: $100.
  • If the price of Company X stock is somewhere between $50 & $52 at expiration, then the calls options in Leg B will be worthless and you will have no further liabilities. The ones in Leg A will be in the money and worth something. Your profit will be the net credit plus the value of the options owned.
  • If the price of Company X stock is at $55 at expiration, then the calls in Leg A will be worth $5 each, for a total value of $500. The ones in Leg B will be worth $3 each, for a total of $900. This loss of $400 is partially offset by the $100 initial net credit received for a total loss of $300. This loss would be greater if the price of the underlying security is any higher.

The following calculations can be used to determine how this strategy can profit, how it will return a loss and what those profits and losses might be.

  • Maximum profit is made “Price of Underlying Security = Strike of Options in Leg B”
  • Maximum profit is “((Strike of Options in Leg B – Strike Price of Options in Leg A) x Number of Options Bought in Leg A) + Net Credit Received”
  • Profit is also made when “Price of Underlying Security = or Strike of Options in Leg A and (Value of Options in Leg A + Net Credit)”
  • Losses will be “(Value of Options in Leg B – Value of Options in Leg A) – Net Credit”

Summary

This spread has one particularly clear advantage, in that it can profit if the price of the underlying security either falls or stays the same and it can profit from the underlying security going up. It will only return a loss if the price of the underlying security goes too high and the value of the options written increases above the value of the ones owned.

The downside is that it’s a complicated strategy, and it can be difficult to calculate the optimal ratio to use and the best strikes to use.

Vertical Spreads

The vertical spread is an option spread strategy whereby the option trader purchases a certain number of options and simultaneously sell an equal number of options of the same class, same underlying security, same expiration date, but at a different strike price.

Vertical spreads limit the risk involved in the options trade but at the same time they reduce the profit potential. They can be created with either all calls or all puts, and can be bullish or bearish.

Bull Vertical Spreads

Bull vertical spreads are employed when the option trader is bullish on the underlying security and hence, they are designed to profit from a rise in the price of the underlying asset. They can be constructed using calls or puts and are known as bull call spread and bull put spread respectively.

While they have similar risk/reward profiles, the bull call spread is entered on a debit while the bull put spread can be established on a credit. Hence, the bull call spread is also called a vertical debit spread while the bull put spread is sometimes referred to as a vertical credit spread.

Bear Vertical Spreads

Vertical spread option strategies are also available for the option trader who is bearish on the underlying security. Bear vertical spreads are designed to profit from a drop in the price of the underlying asset. They can be constructed using calls or puts and are known as bear call spread and bear put spread respectively.

While they have similar risk/reward profiles, the bear call spread is entered on a credit while the bear put spread can be established on a debit. Hence, the bear call spread is also called a vertical credit spread while the bear put spread is sometimes referred to as a vertical debit spread.

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What Is a Bear Call Spread?

A bear call spread is an option strategy that involves the sale of a call option, and the simultaneous purchase of a different call option (on the same underlying asset) with the same expiration date but a higher strike price. A bear call spread is one of the four basic types of vertical spreads. As the strike price of the call sold is lower than the strike price of the call purchased in a bear call spread, the option premium received for the call sold (i.e., the short call leg) is always more than the premium amount paid for the call purchased (i.e., the long call leg).

Since the initiation of a bear call spread results in the receipt of an upfront premium, it is also known as a credit call spread, or alternately, as a short call spread. This strategy is generally used to generate premium income based on an option trader’s bearish view of a stock, index, or another financial instrument.

Profiting from a Bear Call Spread

A bear call spread is somewhat similar to the risk-mitigation strategy of buying call options to protect a short position in a stock or index. However, since the instrument sold short in a bear call spread is a call option rather than a stock, the maximum gain is restricted to the net premium received, while in a short sale, the maximum profit is the difference between the price at which the short-sale was effected and zero (the theoretical low to which a stock can decline).

A bear call spread should, therefore, be considered in the following trading situations:

  • Modest downside is expected: This strategy is ideal when the trader or investor expects modest downside in a stock or index, rather than a big plunge. Why? Because if the expectation is for a huge decline, the trader would be better off implementing a strategy such as a short sale, buying puts, or initiating a bear put spread, where the potential gains are large and not restricted just to the premium received.
  • Volatility is high: High implied volatility translates into an increased level of premium income. So even though the short and long legs of the bear call spread offset the impact of volatility to quite an extent, the payoff for this strategy is better when volatility is high.
  • Risk mitigation is required: A bear call spread caps the theoretically unlimited loss that is possible with the naked (i.e., uncovered) short sale of a call option. Remember that selling a call imposes an obligation on the option seller to deliver the underlying security at the strike price; think of the potential loss if the underlying security soars by two or three or ten times before the call expires. Thus, while the long leg in a bear call spread reduces the net premium that can be earned by the call seller (or “writer”), its cost is justified fully by its substantial mitigation of risk.

Bear Call Spread Example

Consider hypothetical stock Skyhigh Inc. which claims to have invented a revolutionary additive for jet fuel and has recently reached a record high of $200 in volatile trading. Legendary options trader “Bob the Bear” is bearish on the stock, and although he thinks it will fall to earth at some point, he believes the stock will only drift lower initially. Bob would like to capitalize on Skyhigh’s volatility to earn some premium income but is concerned about the risk of the stock surging even higher. He, therefore, initiates a bear call spread on Skyhigh as follows:

Sell (or short) five contracts of $200 Skyhigh calls expiring in one month and trading at $17.

Buy five contracts of $210 Skyhigh calls, also expiring in one month, and trading at $12.

Since each option contract represents 100 shares, Bob’s net premium income is =

($17 x 100 x 5) – ($12 x 100 x 5) = $2,500

(To keep things simple, we exclude commissions in these examples).

Consider the possible scenarios a month from now, in the final minutes of trading on the option expiration date:

Scenario 1

Bob’s view proves to be correct, and Skyhigh is trading at $195.

In this case, the $200 and $210 calls are both out of the money and will expire worthless.

Bob, therefore, gets to keep the full amount of the $2,500 net premium (less commissions; i.e., if Bob paid $10 per option contract, a total of 10 contracts means he would have paid $100 in commissions).

A scenario where the stock trades below the strike price of the short call leg is the best possible one for a bear call spread.

Scenario 2

Skyhigh is trading at $205.

In this case, the $200 call is in the money by $5 (and is trading at $5), while the $210 call is out of the money and, therefore, worthless.

Bob, therefore, has two choices: (a) close the short call leg at $5, or (b) buy the stock in the market at $205 in order to fulfill the obligation arising from the exercise of the short call.

The former course of action is preferable since the latter course of action would incur additional commissions to buy and deliver the stock.

Closing the short call leg at $5 would entail an outlay of $2,500 (i.e., $5 x 5 contracts x 100 shares per contract). Since Bob had received a net credit of $2,500 upon initiation of the bear call spread, the overall return is $0.

Bob, therefore, breaks-even on the trade but is out of pocket to the extent of the commissions paid.

Scenario 3

Skyhigh’s jet-fuel claims have been validated, and the stock is now trading at $300.

In this case, the $200 call is in the money by $100, while the $210 call is in the money by $90.

However, since Bob has a short position on the $200 call and a long position in the $210 call, the net loss on his bear call spread is: [($100 – $90) x 5 x 100] = $5,000

But since Bob had received $2,500 upon initiation of the bear call spread, the net loss = $2,500 – $5,000

= -$2,500 (plus commissions).

How’s this for risk mitigation? In this scenario, instead of a bear call spread, if Bob had sold five of the $200 calls (without buying the $210 calls), his loss when Skyhigh was trading at $300 would be:

$100 x 5 x 100 = $50,000.

Bob would have incurred a similar loss if he had sold short 500 shares of Skyhigh at $200, without buying any call options for risk mitigation.

Bear Call Spread Calculations

To recap, these are the key calculations associated with a bear call spread:

Maximum loss = Difference between strike prices of calls (i.e., strike price of long call less strike price of short call) – Net Premium or Credit Received + Commissions paid

Maximum Gain = Net Premium or Credit Received – Commissions paid

The maximum loss occurs when the stock trades at or above the strike price of the long call. Conversely, the maximum gain occurs when the stock trades at or below the strike price of the short call.

Break-even = Strike price of the short call + Net Premium or Credit Received

In the previous example, the break-even point is = $200 + $5 = $205.

Bear Call Spread Advantages

  • The bear call spread enables premium income to be earned with a lower degree of risk, as opposed to selling or writing a “naked” call.
  • The bear call spread takes advantage of time decay, which is a very potent factor in option strategy. Since most options either expire or go unexercised, the odds are on the side of the bear call spread originator.
  • The bear spread can be tailored to one’s risk profile. A relatively conservative trader may opt for a narrow spread where the call strike prices are not very far apart, as this will reduce the maximum risk as well as the maximum potential gain of the position. An aggressive trader may prefer a wider spread to maximize gains even if it means a bigger loss should the stock surge.
  • Since it is a spread strategy, a bear call spread will have lower margin requirements as compared to selling naked calls.

Bear Call Spread Disadvantages

  • Gains are quite limited in this option strategy, and may not be enough to justify the risk of loss if the strategy does not work out.
  • There is a significant risk of assignment on the short call leg before expiration, especially if the stock rises rapidly. This may result in the trader being forced to buy the stock in the market at a price well above the strike price of the short call, resulting in a sizable loss instantly. This risk is much greater if the difference between the strike prices of the short call and long call is substantial.
  • A bear call spread works best for stocks or indices that have elevated volatility and may trade modestly lower, which means that the range of optimal conditions for this strategy is limited.

The Bottom Line

The bear call spread is a suitable option strategy for generating premium income during volatile times. However, given that this strategy’s risks outweigh its gains, its use should be restricted to relatively sophisticated investors and traders.

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