Ratio Call Spread

 

Description

 

The Ratio Call Spread is the opposite of a Call Ratio Backspread in that we are net short options. This means we are exposed to uncapped risk and can only make a limited reward. As such, this is an undesirable strategy, and you would be better off trading one of the long butterflies.

 

The Ratio Call Spread involves buying and selling different numbers of the same expiration calls. Typically we sell and buy calls in a ratio of 2:1 or 3:2, so we are always a net seller. This gives us the uncapped risk potential. It also reduces the net cost of doing the deal such that we create a net credit.

 

Market Opinion

 

Bearish.

 

P/L

 

 

 

 

 

 

 

When To Use

 

Use this strategy in a neutral to bearish environment when you expect decreasing volatility and the stock to remain rangebound, when you are looking to generate income.

 

Example

 

XXXX is trading at $27.65 on May 10, 2011.

Buy one June 2011 25 strike call at $3.11.

Sell two June 2011 $27.50 strike calls at $1.52.

 

Benefit

 

If you guessed correctly and the stock remains rangebound, net credit earned.

 

Risk vs. Reward

 

The risk is unlimited. The reward is the difference in the strike prices plus the net credit, multiplied by the number of long contracts.

 

Net Upside

 

Income earned.

 

Net Downside

 

Unlimited risk if the stock increases in price.

 

Break Even Point

 

Break even up: lower strike plus difference between strikes, multiplied by number of short contracts, divided by number of short contracts minus number of long contracts, plus net credit received or net debit paid.

 

Break even down: lower strike, minus net debit divided by number of long contracts.

 

Effect Of Volatility

 

Increasing volatility is negative because of our exposure to uncapped risk. The best thing that can happen is that the stock does not move at all.

 

Effect Of Time Decay

 

Positive. You are selling more contacts than you are buying. You want your exposure to be preferably one month or less.

 

Alternatives Before Expiration

 

You can close out the position if the stock increases above stop loss.

 

At least one month in advance of expiration, close out the position to stem loss and capture profit.

 

Alternatives After Expiration

 

Close the position by buying back the calls sold and selling the calls bought.