Short Call Ladder : Profit From Increased Volatility

Introduction To Short Call Ladder Option Strategy

Short call ladder

The short call ladder is also known as a bear call ladder. It is not to be confused with the long call ladder. The long call ladder is a bet on low volatility conditions while the short call ladder is a bet on heavy volatility conditions of the underlying security. The short call ladder, like the long call ladder, is created with call options. The difference however, is in the way it is constructed. A long call ladder consists of a long call and 2 other short calls at different exercise(strike) prices while the short call ladder involves a short call and 2 other long calls at different exercise(strike) prices. As a result, it is an unlimited profit strategy with a limited potential loss.

Long call ladder vs short call ladder

The long call ladder relies on low volatility in order to exit at a profit while a short call ladder needs a volatile environment in order to exit at a profit.

Steps

Step 1 : Perform economic, fundamental and technical analysis
Step 2 : Outlook – Increase Volatility
Step 3 : Study the option chain
Step 4 : Breakeven Analysis
Step 5: Understand Your Profit Zones
Step 6 : Limited loss potential
Step 7 : Maximum loss calculation for a short call ladder
Step 8 : Unlimited profit potential
Step 9 : Profit calculation for a short call ladder
Step 10 : Calculate Risk & Reward Ratio
Step 11 : Set Up Trade : Executing A Short Call Ladder
Step 12 : Exit Trade & Record Trade In Diary

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Step 1 : Perform economic, fundamental and technical analysis

Perform economic, fundamental and technical analysis in anticipation of an increase in volatility with a bias towards an increase in the price of the underlying security. Keep an eye out on upcoming news, events, product launches which may be view positively or negatively by the market. Some of the chart patterns traders should look out for are:

Read : Basic Economic Analysis, Basic fundamental Analysis and Introduction to technical analysis

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Step 2 : Outlook – Increase Volatility

The trader that uses a short call ladder is betting that the underlying security will experience an increased volatility. When the price of the underlying security is volatile, there is a higher probability of earning a profit. This strategy however has an upside bias as the ratio of long calls to short calls is 2 : 1. When the price of the underlying security moves upwards significantly, the trader will stand a chance of earning a greater profit. In general, the greater the magnitude of the upward price move, the greater the realizable profit.

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Step 3 :Study the option chain

Examine the options chain to select the options to be used for the construction of a short call ladder.

Read :  Learn to read and understand options chain

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Step 4 : Breakeven Analysis

There are 2 breakeven price points in a short call ladder strategy. There is an upside breakeven price point and a downside breakeven price point.

At these 2 price points, there is neither profit nor loss. But if the price of the underlying security trades above the upside breakeven point or below the downside breakeven point, a profit is realizable.

The breakeven points can be calculated by formulae.

The formula for calculating the downside breakeven point is:

Strike price of written call – net credit

The formula for calculating the upside breakeven point is :

Strike price of lower strike long call + Strike price of higher strike long call – strike price of written call + net credit

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Step 5: Understand Your Profit Zones

Short call ladder

Once the breakeven points are calculated, the trader will know where the profit zones are for the short call ladder.

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Step 6 : Limited loss potential

The short call ladder has a limited loss potential. For that reason, the maximum loss can be calculated via formulae. The maximum loss occurs when the price of the underlying security trades between the exercise(strike) prices of the bought calls.

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Step 7 : Maximum loss calculation for a short call ladder

The maximum loss can be calculated as:

Strike price of the bought call with the lower strike price – strike price of written call – net credit + commissions paid to the broker

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Step 8 : Unlimited profit potential

Unlimited Profit Potential when the price of the underlying security increases

The short call ladder has an upward bias. Examine the payoff diagram. The greater the price of the underlying security, the greater the profit. As long as the price of the underlying security is greater than the upside breakeven point, a profit is realizable.

Limited profit potential as the price of the underlying security decreases

As the price of the underlying security decreases, the profit tends towards a limitation. Hence, there is limited profit potential as the price of the underlying security decreases.

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Step 9 : Profit calculation for a short call ladder

The calculation of the profit depends on the movement of the underlying security. When the price of the underlying security decreases, the maximum profit can is:

Net credit received

As the price of the underlying security moves above the upside breakeven point, the maximum profit can be calculated as:

Price of the underlying security – upside breakeven price point

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Step 10 : Calculate Risk & Reward Ratio

Estimate the risk and reward ratio based on multiple price points. Arrive at a decision as to whether the trade is attractive relative to trades of a similar nature.

Read more : Understanding Risk/Reward Ratio For Option Traders

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Step 11 : Set Up Trade : Executing A Short Call Ladder

A short call ladder involves call options at different strike prices S1, S2 and S3.

S1 < S2 < S3

A trader who executes a short call ladder will:

  • Write 1 in the money call @ S1
  • Buy 1 at the money call @ S2
  • Buy 1 out of the money call @ S3

The ratio of short in the money calls to long at the money calls to long out of the money calls is 1 : 1 : 1. As long as this ratio is adhered to, the trade is a short call ladder. For example, if a trader writes 10 in the money calls at a strike price of $15, buy 10 at the money calls at a strike price of $20 and buy 10 out of the money calls at a strike price of $25, that would be considered as a short call ladder.

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Step 12 : Exit Trade & Record Trade In Diary

After the trade has been exited, the trader should record the trade’s performance in a diary or a journal. The trader should make every effort to improve on future trades and to become a better trader.

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Example Of A Short Call Ladder

TTT is currently trading at a price of $55. A trader anticipates that there is a high likelihood that there will be increased volatility in the price of the underlying security in the short term. Hence, he executes a short call ladder by:

  • Long Dec 60 call @ $0.80
  • Long Dec 55 call @ $2.50
  • Short Dec 50 call @ $6.30

As a result, the net credit of the short call ladder is:

($6.30 – $0.80 – $2.50) x 100 = $300

When there is a significant movement to the upside in the price of the underlying security, the profit is unlimited. The higher the price of the underlying, the greater the profit. Let us examine an example of this.

If the price of TTT trades at $100 on expiration:

Beginning value Ending value Profit(+) or Loss(-)
Long Dec 60 call $0.80 $40 +$39.20
Long Dec 55 call $2.50 $45 +$42.50
Short Dec 50 call $6.30 $50 -$43.70
Overall profit per share +$38

In this scenario, the total profit is:

$38 x 100 = $3800

As you can see, the profit is $3800, which is, many multiples of the net credit.

The greater the price of the underlying security above the upside breakeven point, the greater the realisable profit. Please refer to the payoff diagram above for a validation of this fact.

If the price of the underlying trades at $35 on expiration:

Beginning value Ending value Profit(+) or Loss(-)
Long Dec 60 call $0.80 $0 -$0.80
Long Dec 55 call $2.50 $0 -$2.50
Short Dec 50 call $6.30 $0 +$6.30
Overall profit per share +$3

The total loss in this scenario is:

$3 x 100 = $300

This is also the net credit collected when the short call ladder was executed.

If the price of the underlying security trades between the strike prices of the long call, between $55 and $60, there will be a capped and limited loss. Let us examine the example where the price of the underlying security trades at $55 on expiration:

Beginning value Ending value Profit(+) or Loss(-)
Long Dec 60 call $0.80 $0 -$0.80
Long Dec 55 call $2.50 $0 -$2.50
Short Dec 50 call $6.30 $5 +$1.30
Overall loss per share -$2

The total loss is thus:

$2 x 100 = $200

This is also the maximum loss of the trade. Therefore, this strategy relies on high volatility in order to exit at a profit. Without volatility, the price of the underlying security will stand a greater probability of making a maximum and limited loss when it trades between the strike prices of the long calls.

Read : Execute A Long call ladder or bull call ladder

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