top of page

Call Ratio Spread - An Option Trading Strategy

A call ratio spread options strategy is a multi-legged and neutral strategy. This

strategy limits the profit potential while the risk is undefined. Traders can benefit via

this strategy if the volatility decreases, time decay, and there is no or low movement

in the underlying asset price.


The call ratio spread comprises three components - One long call option bought

in-the-money, and two short calls sold out-of-the-money at higher strike price. The

two short calls will have the same strike price, and all three options will have the same

expiry date. The call ratio spread can either be opened for a debit or a credit, based

on the options contracts price. Generally, they are open to receiving credit. In major

cases, the stock closes at the short call options strike price at the expiry time.


Call ratio spread from a market perspective:

The call ratio spread options strategy is neutral to bullish. It largely relies on the low

movement of underlying assets in order to achieve maximum profit. In order to

achieve the highest potential profit at the time of expiry, the stock must rise and

close at short-strike prices. Thus, a slightly bullish-biased market is ideal for a call

ratio spread.


Suppose the trader has initiated a call ratio spread strategy for a credit purpose.

Profit potential will be credit received plus the spread width between short and long

call options. Even if the underlying asset closes below the long call options, some

profit can be gained. All options will expire worthlessly, and profit will only be limited

to the initial credit received. Suppose the stock moves higher than the short calls;

traders may experience undefined risk in this strategy.


When the traders expect the underlying asset's price to stay between the short and

long options, they may choose a call ratio spread strategy.


How can I set up the Call Ratio Spread?

A call ratio spread can be said to be a bull call debit spread in which traders sell one

additional call option at the same strike price as the short call option in the spread.

The bull call spread leads to a limited potential to make a profit, whereas it also helps

traders to define the overall risk of the position. The main objective of this strategy is

to close the stock price at short strikes at the time of expiry. It will make the short

contracts expire worthlessly, and traders can profit by selling long calls while they

still have intrinsic value.


If the underlying asset price falls below the long strike, all options will expire worthlessly. The initial debit paid will be the maximum loss to the trader, and if the trader receives any credit, that will be the maximum profit. Because of one naked call and if the stock price exceeds the short call options, traders may experience unlimited risk.


The amount paid or received by the trader while entering the strategy depends on

how far in-the-money long call options are to the stock price and how far the

out-of-the-money short call options are to the stock price.


Understanding the diagram of the call ratio spread:

The call ratio spread diagram represents different outcomes according to the stock

price of the underlying asset. Generally, the stock closes at the short strike price at

the expiry time. When a trader enters the call ratio spread, there are chances that

he may have to pay a premium (debit) or may receive the premium (credit).


If a debit is paid, then the highest potential profit for the trader is the width of the

spread among the long and short strike prices minus the debit paid for entering the

position. If the trader receives a credit, the amount collected and the spread width

between long and short strike prices are the highest profit for this position.


If the underlying asset price falls below the long call option, then the highest profit

and loss are limited, and the amount paid or received at the time of entry will be

considered profit or loss. If the stock price exceeds the break-even point, which is

above the short calls, then the trade may experience the highest loss on this trade.


Let us understand with an example:

Suppose the stock is traded at Rs.52. Then a trader can enter a call ratio spread by

one long call option of Rs.50. Two short calls at Rs. 55. Assume that a trader received

a credit of Rs. 1; Now, if the stock closes at Rs. 55, then the highest profit potential a

trader can get is Rs.600. (total width of the spread Rs. 5 + Rs. 1 credit). The short calls

will expire worthlessly, and traders can sell the long call options at Rs. 5 + Rs.1 credit.

Now, if the stock closes at Rs. 61 at the time of expiry, then the short call options will

cost Rs. 12 (6+6) to exit the trade, while the long call will still have Rs. 11 worth.


As the position has received Rs. 1 while entering, the position might close at break-even

points if the stock is traded at Rs.61. Suppose the stock price closes below Rs.50. All

the call options will expire worthlessly. Only the credit received initially will remain as

the profit, i.e., Rs. 1(100 per contract), and if the stock closes above Rs. 61, then there

are unlimited chances of loss.


Call Ratio Spread - An Option Trading Strategy

How can I enter a Call ratio Spread?

A call ratio spread options strategy is a bull call spread with one naked call option,

which is sold at the same strike price as the short call options. Call ratio spreads are

made up of buy-to-open (BTO) one-in-the-money long call options and sell-to-open

(STO) 2 out-of-the-money short call options; these are above the current stock price,

ensuring all options contracts have the same expiry date.


Traders may vary the number of contracts in buying and selling, but the most used

ratios are 2:1, 3:2 and 3:1. Suppose the stock is trading at Rs. 52. A trader can enter the

call ratio spread by buying one long call at Rs. 50 and 2 short calls at Rs. 55.


While entering the call ratio spread, traders may receive the credit or have to pay the

debit. The amount of the premium depends on various factors such as spread width,

how far the options are from the current stock price, whether they are in-the-money,

out-of-the-money, the level of implied volatility, etc. Suppose an asset seems bullish

in the market in the near future; the out-of-the-money options will be very costly

compared to in-the-money call options.


How can I exit the call ratio spread strategy?

If the stock price is exactly the same as the short strike price at the time of expiry,

then a trader can realize a maximum profit. If the stock closes below the short options

and above the long options, they will expire worthlessly. The long call options that still

have some intrinsic value left can be sold to get some profit.


If the underlying asset price closes below the long call options, then all three options

will expire worthlessly, and no action will be taken. If the stock price closes above the

short call options, then all of them will be in-the-money at expiry, and the trader must

close them to avoid execution and risk.


The impact of time decay on call ratio spread:

The time decay factor or theta works in favour of the call ratio spread. With each

passing day, the value of the options contracts falls, and this leads to a lowering of

the value of the two short-call options. Generally, the theta will start losing its value

as and when the contract approaches the expiry. Traders may get attracted by the

low value of the options and tend to buy the short options contract at the amount

less than they were initially sold, whereas the long options that are in-the-money

will still have some intrinsic value left.


The impact of the implied volatility on a call ratio spread:

Traders take advantage of the low implied volatility in the call ratio spread. Low

implied volatility makes the options premium low. Generally, while entering the call

ratio spread, the implied volatility is high and decreases gradually by the time of

expiry. Low implied volatility will quickly reduce the price of the two short-call options.

Although the future volatility or vega factor is very tough to predict and uncertain, it

might help if traders are aware of its impact on the pricing of the short options.


How to adjust a call ratio spread?

Traders can adjust the call ratio spreads before the contracts expire for various

reasons, such as extending the trade duration or altering the spread ratio. If the price

rises and challenges the short calls, traders may buy extra long calls to reduce the

spread width and make the ratio 1:1, limiting the risk on the position. Remember that

every adjustment costs additional funds to the trader, increases the overall risk on

the position, narrows the break-even point, and limits the profit potential. Further, as

call ratio spreads have two short options contacts, executing them will double the risk

before expiration.


Traders must consider external factors such as dividends while planning to adjust

the call ratio spread. If traders want to extend the trade duration or wish to allow

strategy some time to come back into the profit zone, they may close the entire

position and reopen it with some future expiry date. Traders may choose the same

strike price as before or alter it based on the underlying asset's movement. If the

stock has moved above the break-even point, then closing the position would be

better than adjusting it.


How to roll a call ratio spread?

Call ratio spreads can be profitable when they close near to stock price or at a specific

price at the time of expiry. If the trader feels the position is not profitable and wishes

to extend the duration of the trade, then the trader may close the entire position and

reopen it again with some future expiry date. The more time the position has, the

higher the options prices will be. The rollout may cost additional expenses and

increase the risk on the position based on the initial credit or debit.


If the stock price has gone beyond the short call options price, then the trader may

close the existing position and enter a new call ratio spread with either the same

strike price or the price near the current stock price. If by doing so, the debit is rising

above the width of the spread, then it does not make any sense, as it will reap no

profit.


How to hedge a call ratio spread:

The easiest and most common way to hedge the call ratio spread is to buy additional

long call options and reduce the ratio. Buying an additional long call option makes

the spread either bull or bear spread. The trader does not need to protect the spread

from the downward movement, as the long options have already defined the risk.


If the traders are concerned about the upwards movement, they may purchase long

call options above the short strikes. By doing so, the trader is creating the bear call

spread, which will protect the position against any upward move in the underlying

asset price. If the stock moves beyond the break-even point, traders may close the

position instead of hedging it.


So, this was all about the call ratio spread strategy, in which various ratios of the long

and short call options are either bought or sold to profit. We hope you are all clear with the call ratio spread options strategy, and if you require any help, you may contact our expert team to get the necessary support and service.

35 views

Recent Posts

See All

Comments


bottom of page