Bullish Ratio Call Spread
Meaning of a Ratio Spread
A ratio spread is a kind of options strategy. It is a neutral strategy where an investor holds long and written or short options in an unequal proportion. The name arrives from a trade with a certain ratio of short to long positions. In this structure, the most common ratio is twice the long positions as compared to short.
In a ratio call spread, the trader buys one at-the-money (ATM) call option in a slightly bullish market while selling or writing two call options at a higher out-of-money (OTM) call.
The max profit a trader can make using this strategy is the difference between the long and short strike price and the credit they receive (if any). However, the strategy is highly risky, as the potential loss one can incur using this approach is theoretically unlimited. Thus, traders should use this option only when they understand market conditions and invest a limited amount as per their risk appetite.
What Are Its Components?
For ratio call spread, the components include - purchasing a call or put option, ATM or OTM, and further selling two OTM options.
Buying and selling calls in this type of structure is a call ratio spread. Whereas buying and selling puts in this type of structure is called put ratio spread.
How Does Ratio Spread Work?
The ratio spread strategy is used when traders believe that the underlying asset won't fluctuate much. A trader may be slightly bearish or bullish depending upon the ratio spread trade.
If the trader is slightly bearish, they will go for the put ratio spread. If the trader is slightly bullish, they will go for the call ratio spread. Therefore, ratio call spread is a two-transaction-based strategy. A trader has to buy and write calls in this strategy with the same expiry date but different strike prices.
The written calls here should be more OTM than the ones you buy. Generally, for each long option, there are two written options. However, this ratio can also be altered.
If the trader writes more calls, they will get more premiums to buy the calls and vice versa. Thus, when written calls are more in number, the trader stands a higher chance to earn a net credit. However, if the security price increases more than expected, the trader loses money. So when using this approach, the trader needs to keep in mind the premiums and the market outlook before making any additional call decisions.
More About a Bull Ratio Spread
A bullish ratio spread is an advanced options strategy in trading. As the name suggests, it is used in bullish market conditions.
When there is a bullish outlook for underlying security or towards the market conditions, traders opt for this bullish options trading strategy. A bull ratio spread is often called an extension of a bull call spread.
It may be a little complicated, but it provides more flexibility in trading. Potential profit is a significant difference between a bull ratio spread and a long call. A bull ratio spread allows the trader to book profits even if the security does not increase or decrease at prices.
Therefore, this strategy is not recommended to beginners while trading. It requires a huge level of expertise which is gained only through experience.
When Is a Bull Ratio Spread Used?
It is used to book profits if the trader is slightly bullish in his outlook. It implies that if there is an expectation of a rise in the underlying security price shortly, the trader can go for a bull call ratio spread.
Its flexible nature allows it to go through trade that earns multiple profits.
Let's have a look at an example for a clear understanding of this strategy:
Suppose NIFTY50 is at 7743, and you expect it to hit 8100 by the end of expiry. In this bullish outlook, you can implement a Ratio Call Spread in the following way:
- Selling one lot at 7600 (ITM)
- Buy two lots at 7800 (OTM)
The strategy can now pay off in the following scenarios:
Scenario 1:
Market at 7400 (below the lower strike price)
Scenario 2:
Market at 7600 (at the lower strike price)
Scenario 3:
Market at 7645 (at lower strike price plus net credit)
Scenario 4:
Market at 7700 (between the lower and higher strike price)
Scenario 5:
Market at 7800 (higher strike price)
Scenario 6:
Market at 7955 (higher strike)
Scenario 7:
Market at 8100 (expected target)
At various levels, the eventual payoff from this strategy will be as follows:
| Market Expiry | LS Payoff | HS Payoff | Strategy Payoff |
|---|---|---|---|
| 7000 | 201 | -156 | 45 |
| 7100 | 201 | -156 | 45 |
| 7200 | 201 | -156 | 45 |
| 7300 | 201 | -156 | 45 |
| 7400 | 201 | -156 | 45 |
| 7500 | 201 | -156 | 45 |
| 7600 | 201 | -156 | 45 |
| 7700 | 101 | -156 | -55 |
| 7800 | 1 | -156 | -155 |
| 7900 | -99 | 44 | -55 |
| 8000 | -199 | 244 | 45 |
| 8100 | -299 | 444 | 145 |
| 8200 | -399 | 644 | 245 |
| 8300 | -499 | 844 | 345 |
| 8400 | -599 | 1044 | 445 |
| 8500 | -699 | 1244 | 545 |
The above cases were the major categories, and you can face any of them while implementing this trading strategy.
This indicates that you need to pick the strike price carefully because if the security falls below the strike price, you may lose money in the bull ratio spread.
You may even find benefits from a fall in the price, but you need to have a different ratio spread for that.
Minimisation of Risk While Using a Bull Ratio Spread
Incurring loss in a bull ratio spread entirely depends upon choosing the strike prices. The strike prices can be adjusted to make money even if the security falls in price.
However, selecting the right ratio and appropriate strike prices is crucial. It would be best to choose the strike price depending on the market's expected move. In this way, you can avoid losses.
What Are The Advantages of This Strategy?
The trader gets flexibility in choosing the ratio and strike prices. It enables him to make money even when the price of a security falls. The type of ratio followed by the trader also decides the kind of spread created.
The trader can go for writing more calls if he wants to obtain a credit to minimise the upfront cost of this strategy.
What Are The Disadvantages Of This Strategy?
As selecting strike price and ratio involves a lot of analysis, it can be difficult.
It is a complex strategy as several transactions are executed. Due to the nature of the strategy, it is advised for beginners to avoid this strategy.
Bull Ratio Spread In a Nutshell
A bull ratio spread is a trading strategy of options that can make money for you. It can help you earn in a bullish market and even when the security prices fall. Since the Bull Ratio Call Spread has a high risk associated with it, you can choose the call ratio and strike price according to your analysis.
You can make money even when the security price falls if you have applied the correct ratio. So, you can apply for a bull ratio spread provided you have a bullish outlook towards the market movement, and there is an expectation that the security would rise to a certain level.
You can create a credit spread by increasing the ratio when you write the calls simultaneously. This spread helps you reduce the upfront cost of implementing and executing the strategy.