Bullish- Call Ratio Back Spread

What is the Bull-Call Ratio Back Spread?

The Bull-Call Ratio Back Spread is a credit spread that involves going short a call and long two out-of-the-money calls with the same strike price but different expirations. To get more specific, you would sell one closest to the expired call (Strike A) and buy two calls with a further expiration (Strike B). This strategy creates a net debit when you sell the call and makes a credit when you buy the two out-of-the-money calls.

The Bull-Call Ratio Back Spread can help manage risk while trying to accomplish your investment objectives. Various short and long strikes may be used to tailor the strategy to meet your goals.

Illustration of Bull-Call Ratio Back Spread Through an Example:

You bought 1,000 shares of ABC stock at $40 per share and sold a call (Strike A) with a $40.00 or higher strike price. You would now have one long call position and two out-of-the-money calls with strikes A = 40.00 and B = 40.50, with the B call being further out-of-the-money than A. Your net debit is the original selling price of your call (40) plus the annual premium for your long call position (typically 2). Your net credit is the two annual premiums from each long call.

In this example, you only want to keep the position when A = 40 and B = 40.50 (strike A = strike B). In that case, your profit would be $500 per option:

Max Profit Potential

From the maximum possible payoff, you could get a $1,250 profit for each short call if ABC rose above $41.50 at the call's expiration in June. This would be 1,000 shares of stock x (0.5) x ($41.50 - $40) or $1,250 per option contract ($41.50 -$40). This illustrates the maximum potential payoff for this trade.

Even though a 1,000 share position would meet your investment objective of $500 per contract, you could not expect this to happen. Most likely, your stock would be trading below $40 at the expiration of the call in June, and you would end up losing money on the position. It's much better to reach a maximum potential payoff from your position than hope it reaches that level.

If ABC goes above $41.50 at expiration in June, you will close out the position by buying Strike B calls at 40.50 and selling them back to the market at their current prices (40). To average down the credit and make a profit, you would need a cash adjustment by selling enough stock shares to bring your position's cost down to zero. The more shares you sell, the better. You would have closed out your position at a profit or breakeven with that done.

The Strategy of Bull-Call Ratio Back Spread:

The Bull-Call Ratio Back Spread strategy is a type of debit spread executed by selling a call and buying two out-of-the-money calls with the same strike price but a different expiration.

• This strategy creates a net debit when you sell the call and makes a credit when you buy the two out-of-the-money calls.
• This strategy is typically used as an alternative to buying one or more call options with the same strike price.
• Buying calls has several disadvantages compared to this strategy.
• Buying calls involves paying a premium for the privilege of increasing your position's holdings in the underlying stock.
• The cost of that premium is greater than the cost of the premiums for this strategy, which involves two call options rather than just one.
• Buying calls also locks you into an investment in the stock if it doesn't perform as expected.

Strategy Table:

Detailed Overview of the Steps Taken for the Bull-Call Ratio Back Spread

Advantages of the Bull-Call Ratio Back Spread:

• You always make money no matter what the stock does. No matter how high or low your stock goes at expiration, you will make money on this trade by selling one long call and buying two out-of-the-money calls.
• You don't need to buy an in-the-money call to add value to your position. When you sell a call with a strike price of $40, the only points of reference for your trade are the prices where you can buy and sell one or both of your short options. This strategy can be executed by finding the prices where you can sell your long call and then finding out what strike price and expiration date you would need to buy your short calls to get a net credit before interest and transaction costs.
• You only need a small margin requirement if you use this strategy. If you are trading on margin, you will only need a small amount of available cash to invest in this trade. Using fewer dollars for your investment means more money for other trades with better potential.
• Your risk is limited no matter how high or low the stock goes at expiration.

Disadvantages of the Bull-Call Ratio Back Spread:

• The maximum potential for a Bull-Call Ratio Back Spread is less than other strategies.
• If your stock does not reach the strike price at expiration, you will pay more for your position in calls. The more the stock falls, the more you will have to pay.
• You must wait until the options expire before you can realise any profits from this strategy. Since this involves selling options, it's important to watch them closely and time your adjustments correctly
• You have to watch your stock because a decline in the price could mean that you will have to pay more for your position in calls.

Risks of the Bull-Call Ratio Back Spread :

• The maximum potential for the Bull-Call Ratio Back Spread is less than that of other strategies.
• You may end up with a larger long call position if your stock moves against you.
• Selling options involve a brokerage charge and commissions on each separate transaction. This increases your overall costs and might make this strategy not worth the effort.

Wrapping Up

This article showed you how to buy call options to sell at a premium and then buy call options to create a speculative position in the underlying stock. The Bull-Call Ratio Back Spread is a dynamic strategy used with one or more strike prices. It does not require you to purchase an out-of-the-money call option, which gives it an advantage over other processes that require you to purchase an in-the-money option.