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Call Ratio Backspread

call ratio backspread

call ratio backspread


the call backspread (reverse call ratio spread) is a bullish strategy in options trading that involves selling a number of call options and buying more call options of the same underlying stock and expiration date at a higher strike price. it is an unlimited profit, limited risk options trading strategy that is taken when the options trader thinks that the underlying stock will experience significant upside movement in the near term.
call backspread construction

short straddle construction
sell 1 ainhe money call
buy 2 out the money calls

a 2:1 call backspread can be implemented by selling a number of calls at a lower strike and buying twice the number of calls at a higher strike.

call-backspread

unlimited profit potential

the call back spread profits when the stock price makes a strong move to the upside beyond the upper breakeven point. there is no limit to the maximum possible profit.

the formula for calculating profit is given below:
  •   maximum profit = unlimited
  •   profit achieved when price of underlying >= 2 x strike price of long call - strike price of short call +/- net premium paid/received
  •   profit = price of underlying - strike price of long call - max loss

limited risk

maximum loss for the call back spread is limited and is taken when the underlying stock price at expiration is at the strike price of the long calls purchased. at this price, both the long calls expire worthless while the short call expires in the money. maximum loss is equal to the intrinsic value of the short call plus or minus any debit or credit taken when putting on the spread.

the formula for calculating maximum loss is given below:

  •   max loss = strike price of long call - strike price of short call +/- net premium paid/received + commissions paid
  •   max loss occurs when strike price of long call

breakeven point(s)

there are 2 break-even points for the call backspread position. the breakeven points can be calculated using the following formulae.

  •   upper breakeven point = strike price of long call + points of maximum loss
  •   lower breakeven point = strike price of short call

example

suppose xyz stock is trading at $43 in june. an options trader executes a 2:1 call backspread by selling a jul 40 call for $400 and buying two jul 45 calls for $200 each. the net debit/credit taken to enter the trade is zero.

on expiration in july, if xyz stock is trading at $45, both the jul 45 calls expire worthless while the short jul 40 call expires in the money with $500 in intrinsic value. buying back this call to close the position will result in the maximum loss of $500 for the options trader.

if xyz stock rallies and is trading at $50 on expiration in july, all the options will expire in the money. the short jul 40 call is worth $1000 and needs to be bought back to close the position. since the two jul 45 call bought is now worth $500 each, their combined value of $1000 is just enough to offset the losses from the written call. therefore, he achieves breakeven at $50.

beyond $50 though, there will be no limit to the gains possible. for example, at $60, each long jul 45 call will be worth $1500 while his single short jul 40 call is only worth $2000, resulting in a profit of $1000.

if the stock price had dropped to $40 or below at expiration, all the options involved will expire worthless. since the net debit to put on this trade is zero, there is no resulting loss.

note: while we have covered the use of this strategy with reference to stock options, the call backspread is equally applicable using etf options, index options as well as options on futures.

commissions

for ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.

however, for active traders, commissions can eat up a sizable portion of their profits in the long run. if you trade options actively, it is wise to look for a low commissions broker. traders who trade large number of contracts in each trade should check out optionshouse.com as they offer a low fee of only $0.15 per contract (+$8.95 per trade).

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