Call Ratio Back Spread Strategy- For Beginners 2024

Learn about alternative strategies to increase your returns and reduce risk in trading. Before investing all your money, understand the power of stock options. Whether your analysis predicts rising, falling, or stable markets, a variety of strategies can increase your efficiency.

An effective strategy is the call ratio back spread strategy. This method allows you to benefit if the market goes up, and even in challenging conditions, you can break even or take a small loss. This is a useful method for those who are anticipating a significant upward movement in asset prices.

By selling one call option and buying two or more at a higher strike price, you can use this strategy. It is a straightforward and effective strategy for anticipating a bullish market, unlike other moderate bullish strategies such as bull call spreads or bull put spreads. Include this strategy in your toolkit for its simplicity and potential payout when you are strongly bullish on a stock or index.

IMPORTANT HIGHLIGHTS

• The call ratio back spread strategy provides the trader with unlimited upside profit opportunities.
• The strategy involves selling one call option and using the premium received to buy a larger number of call options with the same expiration but higher strike price.
• If the call ratio back spread is established at a credit, i.e. the premium received from selling calls is greater than the premium spent on buying other calls, the trader may make a small profit even though the price of the underlying security has fallen significantly.

Call Ratio Back Spread Strategy Understanding

This trading strategy buys and sells call options to create an optimal setup to potentially profit from an upward market movement. The key to success depends on the ratio of long and short positions in call options. In a call ratio back spread, a trader typically sells one call option and uses the premium collected to buy a larger number of call options with the same expiration but higher strike prices.

This strategy offers potentially unlimited upside profits because the trader has long call options over short ones. Common ratios include one in-the-money short call to two out-of-the-money long calls or two out-of-the-money short calls to three in-the-money long calls. If established on credit, the trader may make a small profit if the price of the underlying security falls significantly.

How to Use Call Ratio Back Spread Strategy

When you feel positive about a stock or index going up, you can use a strategy. First, sell a call option that is close to the stock price. Then, buy two call options with higher prices. This is called call ratio back spread. You can also choose a 1:3 ratio, where you sell one call option and buy three. It is important to manage the risks and understand the potential gains beforehand.

Simply put, a call option gives you the right to buy a stock at a specified price for a specified period of time If you buy a call option with a price of $10 when the stock is $10, it is “at-the-money.” If the stock goes up, you make money; If it falls, you only lose the cost of the call option. To fund the purchase of a call option, sell a call option at a price lower than the current stock. This gives you a premium, offsetting the cost of buying the call option.

To use the call ratio back spread strategy:

1. Sell a low cost call option.
2. Buy two high-priced call options.
   Make sure all options have the same end date. The trade may give you a net credit if the proceeds of the sale cover the cost of the purchase.

The result (credit or debit) depends on certain factors such as option prices, their distance, volatility and time to expiration.

Example

—Nifty 50—

The Nifty 50, currently at 21,000, will go higher and you want to use the call ratio back spread strategy. Here is a simplified example for call ratio back spread strategy:

1. Sell One Lower Strike Call Option:
   • Sell a nifty call option with a strike price of 20,800. By doing this, you will receive a premium.
2. Buy two higher strike call options:
   • Buy two nifty call options with strike price as high as 21,200. You pay a premium for each of these.

Make sure all these options have the same expiry date. The strategy aims to benefit from a significant upward movement in the Nifty 50.

Now, the result can go two ways:

• Net Credit Scenario:
  • If the premium you receive from selling the lower strike call option is greater than the combined cost of buying the two higher strike call options, you will have a net credit. This means you received more money than you spent, creating a potential profit.
• Net Debit Scenario:
  • If the premium from the sale is less than the total cost of the purchase, this results in a net debit. You paid more than you got and the success of the strategy will depend on the upward movement in Nifty 50.

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—Bank Nifty—

Bank Nifty, which is currently at 45,000. You decide to use the call ratio back spread strategy. Here’s how you can implement call ratio back spread strategy:

1. Sell a lower strike call option:
   • Sell a Bank Nifty call option with a strike price of 44,500. This option is slightly below the current index level.
2. Buy two higher strike call options:
   • Buy two Bank Nifty call options with higher strike prices, for example, one with a strike price of 45,500 and the other with a strike price of 46,000.

Make sure all these options have the same expiry date, say one month from now.

Now, let’s consider the situation:

• If Bank Nifty goes up: Two higher strike call options benefit from the upward movement and you profit. A sold call option may lose, but the overall gain from a bought option may outweigh the loss.
• If Bank Nifty is near 45,000: The sold call option may become worthless, but you will lose the premium paid for it. Purchased call options also lose value, but the overall loss is limited to the initial premium.
• If Bank Nifty falls: Sold call option may become worthless and you will earn premium. Purchased call options, however, lose value, limiting overall gains.

—U.S Stock Exchange—

Suppose you are optimistic about the stock of Company XYZ, which is currently trading at $50 per share. To implement the call ratio back spread strategy:

1. Sell One Lower Strike Call Option:
   • Sell a call option with a strike price of $48. This means you are agreeing to sell Company XYZ shares at $48 if the buyer chooses to exercise the option.
2. Buy two higher strike call options:
   • Buy two call options with a higher strike price, let’s say $52 With these options, you have the right to buy XYZ shares of Company XYZ at $52 if you decide to exercise the options

All options involved in this strategy should have the same expiration date.

Now, let’s consider two scenarios on the expiration date:

• Scenario 1: Stock price below $48
  • The call option you sold has expired because no one wants to buy the shares at $48 when they can be bought in the market for less.
  • The two call options you bought will also become worthless because the stock price is below their strike price of $52.
• Scenario 2: Stock price above $52
  • The call option you sold at $48 is a loss because you have to sell the shares at less than the market price.
  • The two call options you bought at $52 are profitable because they allow you to buy the stock at less than the market price.

[Remember, this is a simplified example for call ratio back spread strategy, and actual transactions take into account various factors, including option pricing, volatility, and the specific strike price chosen. Always analyze and manage risk before implementing any trading strategy.]

Overview

When trading options, there is no perfect strategy including the call ratio back spread. It’s not foolproof and comes with risks. However, if you manage risks well, you can aim for more profits and fewer losses, putting you in a better position overall.

The call ratio back spread is a strategy that works when you predict a significant increase in a stock’s price. This involves limited losses and potentially unlimited gains if your analysis is correct. Risk management is built-in because directional trades are hedged. You gain more on bought options, lose less on sold call options, and your net loss or gain is zero in case the price goes down.

This strategy creates a net long call position, allowing for unlimited potential profits if the stock price rises. If you place a call spread for net credit, you can profit even if the stock price falls, as long as it remains below the strike price of the call option sold at the time all the options expire. If the position is set up at a net debit, there is no potential profit from a negative move, but the maximum loss is limited to the net debit.

Maximum potential losses occur if, at expiration, the stock price is at the higher strike price of the purchased calls. The loss is equal to the difference between the call strike price bought and sold, minus either the net credit received or the net debit when establishing the position.

Call ratio back spreads have a certain period of time to become profitable. If a credit and risk limit are sold, they are usually not adjusted. However, if the stock price is not in the profit zone, the position may roll up or down. External factors such as dividends should be considered. To avoid assignment risk or extend a trade, you can close and reopen the entire position at a future date with the same or a new strike price.

Hedging may be unnecessary because call ratio back spreads are already a risk-defined bullish position. There is no need to hedge against lower stock movements since the bear call spread defines downside risk. Any sharp decline can result in profit equal to the credit received at the time of entry.

Conclusion

To increase your chances of making money in trading, you can use a technique called “call ratio back spread strategy”. This works well when you think a stock will have a large price swing and high volatility. Look for stocks with above average volatility to find good opportunities.

To make this strategy more powerful, some traders change the normal ratio from 2:1 to a complex ratio like 3:2 or 3:1. This means adding more long call options, which can lead to bigger gains if the stock price goes up a lot.

This strategy is a cousin of another called the “put ratio backspread,” which is used when you expect a stock to decline and become more volatile. In both strategies, you buy some options and sell others to take advantage of certain market movements.

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