Execute A Call Ratio Spread : Profit From Little Volatility

Introduction To Call Ratio Spread Option Strategy

 

A call ratio spread is a strategy that involves an uneven number of call  contracts bought and sold simultaneously on the same underlying security with the same expiration date but with different strike(exercise) prices. The objective of this strategy is to profit from little to no volatility. This strategy when implemented will result in limited potential profit but unlimited risk to the upside. Depending on how the call ratio spread is structured, a net credit or debit may result. As a warning, do note that if the prices do go up significantly, the trader may stand to make a huge loss.

Steps

Step 1 : Perform Economic, Fundamental &  Technical Analysis
Step 2 : Outlook : Profit From Little Volatility
Step 3 : Examine The Option Chain
Step 4 : Perform Breakeven Analysis
Step 5 : Understand Your Profit Zones
Step 6 : Know That A Call Ratio Spread Has Unlimited Loss Potential
Step 7 : Learn To Calculate Your Loss
Step 8 : Understand That A Call Ratio Spread Has Limited Profit Potential
Step 9 : Learn To Calculate Your Maximum Profit Of A Call Ratio Spread
Step 10 : Learn To Calculate Your Risk And Reward Ratio
Step 11 : Setting Up A Call Ratio Spread
Step 12 : Exiting A Call Ratio Spread
Step 13 : Record Your Trade In A Diary

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Step 1 : Perform Economic, Fundamental &  Technical Analysis

It is important to perform economic, fundamental and technical analysis before executing the call ratio spread. Are the markets going sideways?Are there any economic events that will cause markets to trade with increased volatility? Is the price of the underlying security  expected to trade with little volatility. Is there any possibility that the underlying security will increase or decrease in price significantly over the life of the trade? These are questions that one should ask before placing a call ratio spread. This should also be done to screen for potential candidates on which a call ratio spread can be executed.

Some suggested chart patterns to look out for are:

In a falling channel as above, the range of prices that the underlying security will trade can be estimated.  Of course, this is not conclusive. The fundamentals of the company should also be looked into.

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

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Step 2 : Outlook : Profit From Little Volatility

The astute options trader projects little volatility in the underlying security. This increases the probability of achieving maximum profit. More specifically, slight declines or rises in the price of the underlying security does not matter as long as it does not exceed or reach the strike price of the shorted call options. This is a strategy that should not be used on volatile stocks such as technology stocks. However, this option strategy can be used in range bound markets.

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Step 3 : Examine The Option Chain

How does one get the prices of options? One has to look at the option chain. The  prices of the options are dependent on many factors. One of the factors being, the price of the underlying security. Hence, option prices are always in a constant flux of change. It is vital to examine the options chain to determine the options to be used in the execution of the call ratio spread.

Read :  Learn to read and understand options chain

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Step 4 : Perform Breakeven Analysis

Depending on how the call ratio spread is structured, there could be 1 or more breakeven points.

The upside breakeven point is:

Short strike price + ( (Short strike price – Long strike price + Net credit received)/ number of naked call contracts)

Since a 1 : 2 call ratio spread involves buying 1 call and shorting 2 calls at a higher strike price, 1 call is left naked or uncovered.

The downside breakeven point is:

Long strike(exercise) price + net debit

OR

Long strike(exercise) price – net credit

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Step 5 : Understand Your Profit Zones

Once the breakeven points are calculated, you will know what are the profit zones. A profit is realisable between the breakeven points.

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Step 6 : Know That A Call Ratio Spread Has Unlimited Loss Potential

The potential losses in a call ratio spread are unlimited to the upside. As long as the price of the underlying security trades above the upside breakeven point, a loss will result if the trade is closed out.

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Step 7 :  Learn To Calculate Your Loss

The calculation of the loss can be calculated as :

 Brokerage commissions + Price of underlying security – Short strike price – (Short strike price – Long strike price + Net credit received)

Step 8 : Understand That A Call Ratio Spread Has Limited Profit Potential

The profit potential of the call ratio spread is limited. The maximum potential profit is achieved when the price of the underlying security is at the strike(exercise) price of the shorted calls on expiration. In this way, while the shorted calls expire worthless, there is a realisable gain on the long call position.

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Step 9 : Learn To Calculate Your Maximum Profit Of A Call Ratio Spread

The maximum profit can be calculated by using a formula. The formula is:

Short strike(exercise) price – Long strike(exercise) price + Net credit received – Brokerage commissions

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Step 10 : Learn To Calculate Your Risk And Reward Ratio

Once you are able to calculate your risk and reward, you should calculate your risk and reward ratio. Assuming you put certain stop losses in place over the life of the options involved, what is your potential profit for every dollar of risk that you are taking? Is a call ratio spread worth executing?

 Read : Understanding Risk/Reward Ratio For Option Traders

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Step 11 : Setting Up A Call Ratio Spread

To execute a call ratio spread, long 1 call and short 2 calls at a higher strike(exercise) price. The ratio of long to short calls is thus 1:2 .

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Step 12 : Exiting A Call Ratio Spread

  • If the price of the underlying security moves beyond the price at which maximum profit is achieved, the trader may wish to close the trade by buying back the short calls and selling the long call.
  • If the price of the underlying security drops and if the trader is in net credit position, the trader can just let the options expire worthless and keep the credit.

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Step 13 : Record Your Trade In A Diary

After you have exited your trade, record your trade process, thought processes in a library. Figure out what were your mistakes and try not to make the same mistakes in your next trade. Also, find out what could be done better.

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Example

A trader decides to create a call ratio spread in the month of February on ABC Corp as he anticipates little volatility in the underlying security and a possible slight rise in the price of the underlying security. He does so by buying 1 July 50 at-the-money call at a price of $4.50 and selling 2 July 55 calls at a price of $2.50 each. Because the strike(exercise) price of the shorted calls is further away from the current market price of $50 , the short calls are worth less than the long call.

By executing the call ratio spread in this example, a net credit is created. In other instances for call ratio spreads, net debits may result.

The net credit can be calculated as:

($2.50 x 2 x 100) – ($4.50 x 100) = $50

If the price of the underlying security trades at $60 on expiration:

Beginning value Ending value Profit(+) or Loss(-)
1 July 50 call $4.50 $10 $10 – $4.5 =

(+)$5.50

2 July 55 calls $2.50 $5 ($2.50 – $5) x 2

(-)$5

In total, $500 is lost on the short calls while $550 of profit is made on the long call. As a result, the profit achieved is:

$550 – $500 = $50

If the price of the underlying security trades at $55 on expiration:

Beginning value Ending value Profit
1 July 50 call $4.50 $5 $5 – $4.5

= $0.50

2 July 55 calls $2.50 $0 ($2.50 – $0) x 2

= $5

In this case, there will be a profit of:

($5 + $0.50) x 100 = $550

This is also the maximum profit attainable.

If the price of the underlying security trades at $80 on expiration:

Beginning value Ending value Profit(+) or Loss(-)
1 July 50 call $4.50 $30 $30 – $4.5

= $25.50

2 July 55 calls $2.50 $25 ($2.50 – $25) x 2

= – $45

Hence, in this scenario, there will be a loss of:

$4500 – $2550 = 1950

The greater the increase in price above the upside breakeven point, the greater the losses.

Since a call ratio spread is made up of long and short calls, one should also

read:

Long Call : Profit From Rise In Price Of Underlying security

Short call : Earn premium when option expires

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