Call Ratio Backspread

What Is a Call Ratio Backspread?

A call ratio backspread is an options spreading strategy that bullish investors use if they believe the underlying security or stock will rise by a significant amount while limiting losses. The strategy combines purchasing a greater number of call options in order to sell a lesser number of calls at a different strike but same expiration date. While the downside is protected, gains can be significant if the underlying security rallies significantly due to the ratio feature. The ratio of long to short calls is typically 2:1, 3:2 or 3:1.

A call ratio backspread can be compared with a put ratio backspread, which is bearish and uses puts instead of call options.

Understanding Call Ratio Backspreads

A call ratio backspread is generally created by selling, or writing, one call option and then using the collected premium to purchase a greater number of call options with the same expiration at a higher strike price. This strategy has potentially unlimited upside profit because the trader is holding more long call options than short ones. An investor using a call ratio backspread investing strategy would sell fewer calls at a low strike price and buy more calls at a high strike price. The most common ratios used in this strategy are one in-the-money short call combined with two out-of-the-money long calls or two out-of-the-money short calls combined with three in-the-money long calls. If this strategy is established at a credit, the trader stands to make a small gain if the price of the underlying security decreases dramatically.

For review, a call option gives the option buyer the right, but not the obligation, to buy a stock at a specified price within a specific time period. If an investor buys a call option with a strike price of $10 while the stock is trading at $10, the option is considered at-the-money. If the stock rises to $15, the call option makes money. If the underlying stock falls to $5, the investor loses only the premium paid for the call option and never owns the stock.

In order to finance the premium for purchasing the call options, the investor sells a call option that's in-the-money or below the current stock price. So an investor might sell one call option at a strike price of $13 while the current price of the stock trades at $15 in the market. By selling the call option, the investor gets paid a credit for the premium of the option. The credit offsets the premium paid for buying the call options at the $17 strike price. The offset in premiums could be a partial offset or the credit received could exceed the premium paid for the call options. The premiums charged depend on many factors including the volatility of the stock price.

Using Ratio Backspreads

Backspread strategies are designed to benefit from trend reversals or significant changes or moves in the market. Call ratio backspread strategies benefit most greatly from a rally in the underlying security. The goal of the strategy is for the underlying to rise above the strike price of the purchased call options. Ideally, the price needs to go high enough to compensate for any premium paid for the call options. However, the sale of the option that's in-the-money is placed to pay the investor a credit to offset or finance the purchase of the call options.

Using the example above, the investor would want the stock price to rise from $15 to well above the $17 (the strike price for the call options) and earn enough to more than pay for any premium for purchasing the call options.

Call ratio back spread strategies are designed to benefit from increases in market volatility. Investors typically employ them when they believe financial markets are poised to move higher. By simultaneously buying and selling call options, traders can hedge their downside risk, while benefiting from the upside as markets gain. Backspread strategies can be used on a standalone basis, to “go long” the market. Alternatively, they can be used as part of a larger or more complex investing position.

Example of a Call Ratio Backspread

Note that the example below does not factor any commissions from a broker, which need to be considered before executing any strategy.

Let's say you're an investor who's bullish on the stock of XYZ Company and you believe the stock could rise significantly in the short term.

In the above example, the stock price has to move high enough whereby you make enough money on the two at-the-money call options combined with the initial credit to more than offset any loss from the one in-the-money option that you initially sold.

Let's say in the example; the stock moved to $26 by expiry.

Let's say in the example; the stock moved to $10 by expiry.

Call Ratio Backspread vs. Put Ratio Backspread?

A put ratio backspread is a bearish options trading strategy that combines short puts and long puts to create a position whose profit and loss potential depends on the ratio of these puts. A put ratio backspread is so called because it seeks to profit from the volatility of the underlying stock, and combines short and long puts in a certain ratio at the discretion of the options investor.

The put ratio spread is similar to call ratio spread, but instead of buying two or more call options and selling one call option to finance the strategy, you would buy several put options and sell one put option to help finance the purchase of the two puts.

If the stock goes down by a significant amount, the strategy earns money from the two puts to offset any loss from the one put that was sold.