Options are derivative contracts that are not only helpful in hedging but also provide traders with a viable way to generate substantial profits. However, several traders end up booking losses while trading options. With the help of certain strategies, one can trade options while limiting the losses. The call ratio backspread is one such strategy that a trader can deploy. Let’s take a close look at it.
The call ratio backspread strategy is a bullish option spread strategy that can be deployed when a trader expects the price of the underlying asset to rise significantly. Being a spread strategy, it involves buying and selling options in a particular ratio.
According to the call ratio backspread strategy, a trader buys a large number of call options and sells a lesser number of call options at a different strike price of the same expiry. Through the buying and selling of call options, the trader limits the downside while the gains could be higher if the price of the underlying asset rallies significantly.
Before we dive deeper into the strategy, let’s go over what a call option is.
A call option is a derivative contract that gives the holder the right but not the obligation to purchase a security at a given price within a specific duration. Being a derivative contract, the value of the call option increases with a rise in the price of the underlying asset and decreases with a fall in the price of the underlying asset.
By deploying the call ratio backspread strategy, the trader limits the downside while the potential gains can be unlimited. This is possible due to the ratio in which the call options are sold and bought. By selling the call options, the trader can collect the premium which can be used to purchase a larger amount of call options. The strategy limits the downside since the number of short-call options is lesser than the number of long-call options. Typically, the strategy is executed in a ratio of 1:2, 1:3, or 2:4.
The call ratio backspread is a useful bullish strategy. Let’s look at an example to learn how to trade this strategy and how the trade would fare in different scenarios.
If an asset is trading at Rs 500 and a trader expects the price of the asset to rise, the trader can make use of the call ratio backspread strategy.
Per this strategy, the trader will sell one lot of an in-the-money (ITM) call option (CE) and purchase two lots of out-of-the-money (OTM) call options. This results in a ratio of 1:2.
So, the trader will sell one lot of 490 CE (ITM) and purchase two lots of 520 CE (OTM).
The 490 CE is trading at Rs 200 – Total premium collected = Rs 200
The 520 CE is trading at Rs 80 – Total premium paid 80x2 = Rs 160.
Net cash flow = 200 – 160 = Rs 40.
Four primary scenarios may unfold.
In this scenario, the price of the underlying asset falls below the strike price of the sold call i.e. Rs 490. If the asset is trading at Rs 460, the trader will be able to collect the entire premium of the sold call while the bought call will expire worthless.
Net profit - 200-160 = Rs 40
If the price of the asset rises and is between the strike prices of the sold and bought call options, the trade will be in a net loss. If the price of the asset rises to Rs 515, the 490 CE will incur a loss, while the 520 CE will expire worthless. The net loss would vary depending on how far the price of the underlying asset is from the strike prices.
490 CE – 260-200 = -60
Net loss = 160 + 60 = Rs 220
If the price of the asset rises significantly, the premiums of the bought call option would swell as they are pushed to ITM. The losses of the sold call option will be offset by the gains in the bought call option due to the ratio spread.
If the asset’s price rises to Rs 540,
490 CE – 200-300 = -100
520 CE – (200-80) x 2 = 240
Net profit = 240 – 100 = Rs 140
The trade breaks even in two different situations. If the price of the asset is slightly higher than the sold strike price, the premium collected will offset the premium paid for the bought call. Similarly, if the asset price rises slightly higher than the bought call option’s strike price then the gains from the bought calls will offset the losses of the sold call option.
The call ratio backspread strategy is a complex yet beneficial strategy that traders can deploy when they have a bullish outlook. The limited downside along with the potential of an unlimited upside makes this a suitable strategy for volatile markets when significant price moves are expected.
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