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.