A Bull Call Ratio Backspread is a bullish strategy and is potentially an alternative to simply buying call options. There are two components to the call ratio backspread:
- Sell one (or two) at-the-money or out-of-the money calls
- Buy two (or three) call options that are further away from the money than the call that was sold.
Call Ratio Backspread Expectations
The ratio backspread is called such because there is a ratio of sold options to purchased option usually in the ratio of 1 sold to 2 purchased, or 2 sold to 3 purchased. A trader would use a Bull Call Ratio Backspread in the following hypothetical situation:
- A trader is very bullish on a particular stock trading at $50.
- The trader is either risk-averse, wanting to know before hand their maximum loss or wants greater leverage than simply owning stock.
- The trader expects the stock to move above $54.67 or not move at all or even fall in the next 30 days. However, a move higher to only $52.50 would prove disasterous for the trade.
Given those expectations, the trader selects the $52.50 call option strike price to buy two calls which are trading for $0.60 each so the total cost will be $120 (2 contracts x $0.60 x 100 shares/contract).
Also, the trader will sell one the at-the money call strike price at $50.00. By selling this call, the trader will receive $153 ($1.53 x 100 shares/contract). The net effect of this transaction is that the trader will receive $33 ($153 received – $120 paid).
Call Ratio Backspreads require Extreme Bullishness
For this trade, a trader must be extremely bullish on the stock. Only being slightly bullish will not work for this trade. One of the strange aspects of a bull call ratio backspread like the one in this example is that the greatest loss occurs in the direction the trader is hoping the trade will move (i.e. upwards).
The greatest loss occurs at the strike price of the purchased call options. The reason for this is that at $52.50, at expiration, the calls the trader purchased expire worthless ($120 loss). Meanwhile, the one call the trader sold has gained value and would be worth $250. The trader sold the call option for $153, so the sold call option has accrued a loss of $97 ($153 – $250). Combined with the loss suffered from the purchased options that expired worthless, the total loss is $217 ($120 + $97). The profit/loss graph on the next page illustrates this.
Once the stock price surpasses the strike price of the purchased calls (i.e. point of max loss), then the losses begin to decrease and eventually a profit occurs. This is because at the point of max loss, one call option that was purchased effectively begins to neutralize the option that was sold. One of the purchased option cancels out the movement of the one sold option. From there, the one remaining purchased option is free to begin to make a profit, just like if the trader only purchased a call option. In order to more clearly understand this past paragraph, the concept of delta must be understood.
Possible to make money if stock goes down
Yet another odd aspect of the bull call ratio backspread is that sometimes the trade will make money if the stock moves in the exact opposite direction the trader is expecting (i.e. downward). For instance, if the stock moves nowhere for 30 days and remains at $50.00, then the two calls the trader purchased would expire worthless ($120 loss). However, the one call the trader sold expired worthless also. Remember, the trader sold the option for $153; therefore, the trader actually gained on the transaction $33 ($153 gain – $120 loss).
The profit/loss graph for the bull call ratio backspread is given on the next page.
Call Ratio Backspread Profit & Loss Graph
The following is the profit/loss graph at expiration for the Bull Call Ratio Backspread in the example given on the previous page.
The breakeven point for the bull call ratio backspread is given next:
- Breakeven Stock Price1 = Sold Call Option Strike Price + Net Premium Sold (Cost of Options Sold – Cost of Options Purchased). Note: This breakeven might not exist with every bull call ratio backspread a trader trades (i.e. if there is net premium purchased rather than sold).
- Breakeven Stock Price2 = Sold Call Option Strike Price + 2 x Distance between strike prices of the call sold and the calls purchased – Net Premium Sold or + Net Premium Purchased.
To illustrate, the trader sold the $50.00 strike price call option for $1.53, and also bought two options at the $52.50 strike price for $0.60 each, for a net premium sold of $0.33 ($1.53 – $1.20). The strike price sold was the $50.00. Therefore, $50.00 + $0.33 = $50.33. The trader will breakeven, excluding commissions/slippage, if the stock is below $50.33 by expiration.
For the second breakeven, the distance between the two strike prices is $2.50 ($52.50 – $50.00). Consequently, 2 times $2.50 is $5.00. The net premium sold was $0.33. The sold call option strike price is $50.00. Summing everything together, $50.00 + $5.00 – $0.33 = $54.67. As such, the two breakeven points are $50.33 and $54.67.
The profit for a bull call ratio backspread is as follows:
- Bull Call Ratio Backspread Profit = Stock price at expiration – Breakeven price
To continue the example, if the stock price at expiration is $56.00, then the profit would be $133 [($56.00 – $54.67) x 100 shares/contract].
To the downside, the max profit is $33 anywhere below the strike price of the option sold. This profit area to the downside might not exist for all bull call ratio backspreads.
A partial loss occurs between the call strike price sold and the call strike price purchased. A partial loss also occurs between the point of max loss and the upper breakeven. The calculation is given next:
- Bull Call Ratio Backspread Partial Loss1 = (Stock Price at Expiration – Strike Price of Option Sold) – Net Premium Sold or + Net Premium Purchased
For example, if the stock price was $52.00 at expiration and the strike price of the option sold is $50.00 and net premium sold was $0.33, then [($52.00 – $50.00) – $0.33] x 100 shares/contract = $167 loss.
- Bull Call Ratio Backspread Partial Loss2 = (Upside Breakeven Stock Price – Stock Price at Expiration)
To illustrate, if the stock price at expiration was $54.00 and the upside breakeven stock price was $54.67, then [($54.67 – $54.00) x 100 shares/contract] = $67.
As stated previously, the max loss occurs at the strike price of the calls purchased. The formula is as follows:
- Bull Call Ratio Backspread Max Loss = (Strike price of calls purchased – Strike price of call sold) + Net Premium Purchased or – Net Premium Sold.
As an example, the strike price of the calls purchased is $52.50, the strike price of the call sold is $50.00, and the net premium sold is $0.33: ($52.50 – $50.00) – $0.33 = $2.17 x 100 shares/contract = $217.
Bull Call Ratio Backspread vs Call Option
Both the profit/loss graph at expiration for the Bull Call Ratio Backspread and a call option are given below.
The call is superior than the bull call ratio backspread when it comes to the better upside breakeven.
- Bull Call Ratio Backspread = $54.67
- Call = $53.10
The profit for a bull call ratio backspread is less than a call. The profit at a stock price of $55 is given below :
- Bull Call Ratio Backspread = $33
- Call = $190
At a stock price of $50 (i.e. stock didn't move in 30 days) the bull call ratio backspread actually makes money, whereas the call loses money:
- Bull Call Ratio Backspread = $33
- Call = -$60
However, at a price of $52.50, the bull call ratio backspread is very inferior to the call.
- Bull Call Ratio Backspread = -$217
- Call = -$60
Like all option strategies, the trader's exact expectations have to be considered when deciding the best strategy to use:
- Direction of stock move
- Magnitude (size) of stock move
- Time frame of stock move