If you want to get rid of downside risk and have found a stock that may move only a little over the next weeks, the call ratio spread might be a strategy to consider. This options setup, ideal for slightly bullish traders, leverages limited stock movement. Today, we’ll define this strategy, look at a call ratio spread example, and learn the essentials.
Key takeaways
- The call ratio spread is an options strategy where traders buy a certain number of call options at a lower strike price and sell more call options at a higher strike price, typically in a 1:2 ratio, to create a spread.
- This strategy is designed to capitalize on moderate price movements, making it ideal for traders with a neutral to slightly bullish outlook.
- Depending on how you build the trade, the call ratio spread carries limited or no downside risk. However, its loss potential is uncapped if the underlying price rises significantly.
What Is the Call Ratio Spread Option Strategy?
The call ratio spread strategy involves buying a certain number of call options and selling a greater number at a different strike price, creating a spread. Here’s a breakdown of its components and mechanics:
- Long Call Positions: Buy a specific number of call options at a lower strike price.
- Short Call Positions: Sell more call options at a higher strike price than you bought, typically in a 2:1 ratio, forming the ratio spread.
The call ratio spread capitalizes on limited price movement by allowing traders to benefit from a neutral to bearish market outlook. It aims to profit from the premium received from selling more options than purchased, while minimizing risk from significant market fluctuations.
This is what the P&L of a typical ratio call spread will look like:
As you can see, this P&L pretty much looks like a naked call, but with a peak corresponding to the strike prices of the calls you sold. You take this trade when you don’t expect the asset to cross your breakeven point, and you want to profit from sideways movement. The bought call also makes it easier to adjust the position if the trends continue to be bullish for longer than initially expected.
When Should You Use a Call Ratio Spread?
To better understand when to use a call ratio spread, there are a few aspects you should take into consideration:
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- Directional Assumption: The call ratio spread offers no (or limited) downside risk and potential profits if the market moves up a limited amount. Initially, these spreads have a negative delta, so an upward move creates a loss. However, maximum profits occur if the short strike aligns with the stock price at expiration.
- Implied Volatility Environment: High implied volatility (IV) is key for ratio spreads. In such conditions, extrinsic values rise, enabling wider spreads while still collecting credit. This expands the breakeven point as the long spread’s value offsets risk beyond the short strike. Moreover, higher premiums can be gathered upfront with narrow spreads in high IV environments compared to low IV scenarios. Additionally, if IV falls after you enter the trade, you can collect more premium from the larger amount of sold options.
- Time decay: Time decay is usually on your side when you trade the call ratio spread. Each day, the time value of the two short calls diminishes, lowering their value as expiration approaches. Ideally, if the underlying stock remains steady, theta accelerates the decline in value of the short options.
Overall, the call ratio spread is most effective when expecting moderate market moves and higher implied volatility. This setup allows traders to manage risk and optimize opportunities through strategic option positioning.
Before we look at an example in the following section, consider this: the classic call ratio spread is called “front call ratio spread,” while its reversed version is referred to as “back call ratio spread.” We’ll mainly look at the front version, so both the features above and the example below refer to this specific case.
How to Use It? A Call Ratio Spread Example
And now, let us turn our attention to a call ratio spread example on IWM (as you know, this is one of the most traded ETFs on the US stock market). Suppose you anticipate that IWM will not experience a significant upward movement over the next few weeks. You want to capitalize on a neutral to bearish market phase while ensuring downside protection if IWM declines more than expected. This scenario makes it an excellent time to consider employing a call ratio spread.
Therefore, you could go to our options screener and find either a long call or a naked call trade opportunity (either one of these will represent one of the two legs of the call ratio spread; you can add the second leg based on your preference and risk appetite). Here’s how you might set it up with IWM trading at $219.41:
- Buy one $210 call: This option provides the right to purchase IWM at $210, establishing a baseline position.
- Sell two $215 calls: By selling these calls, you generate a credit that helps offset the cost of the call you purchased. This setup creates a ratio spread, specifically a ratio call spread, with a typical 1:2 structure.
This is the P&L profile you can expect with the strategy described above:
We see two things to note in the chart above:
- Your breakeven price for this strategy is $225.15. This means IWM can even rise slightly without causing a loss, provided it stays below the breakeven point. If IWM surpasses $225.15, losses increase linearly with no upper limit.
- The maximum profit occurs if IWM closes at $215 upon option expiration. In this situation, you achieve a peak profit of $1,011. The benefit of this call ratio spread example is that if IWM’s price falls more than expected, you still secure a $513 profit due to the credit received from selling the extra call options.
If you want more flexibility, you can find the call ratio spread that corresponds to all your filters on our options screener. All you need to do is create a new scan and go to the dropdown menu to choose the “Call Ratio Spread” strategy. As an example, let’s say you are bearish on Tesla (TSLA), which is now trading at $261.63. On our screener, you could find this trade:
Focus on the fact that, as we have already told you, there’s a potentially unlimited loss risk on the right-hand side of the chart. Also, your breakeven price would be $288.10, meaning you need TSLA to be below this price by the time your calls expire to have a profit. This is a classic 1:2 ratio, but nothing stops you from trying a 1:3 or even higher ratios. Our options screener does just that: you can easily edit the ratio you are looking for in your parameters.
For instance, if we keep the same strike prices and change the ratio from 1:2 to 1:3, we could get this setup (assuming we are not too rigid on the expiration date):
It is fairly easy to spot the differences between the 1:2 and 1:3 case:
- The 1:2 case had lower losses compared to the 1:3 case (e.g., with TSLA trading at $300, you’d lose around $1,200 in the 1:2 case, and nearly $2,000 in the 1:3 setup)
- The breakeven price is no longer sitting at $288.10, being now at $290.57
- In terms of maximum profit, the 1:2 case would give us a little more than $2,300, compared to over $5,000 for the 1:3 ratio
- Both strategies eliminate the downside risk for TSLA. However, they would differ in the amount of money we’d earn in the strongly bearish case for the stock ($310 for the 1:2 ratio vs $3,115 for the 1:3 case).
How to Adjust and Roll a Call Ratio Spread
Let’s go on with the example mentioned above to see how you would normally adjust a call ratio spread. Below is a synthetic table providing tips for adjusting or rolling a ratio call spread applicable to any stock:
If the IWM price rises near the short call positions, you have two main options:
- Add more long calls, turning the ratio spread into a 1:1 bull call spread. This eliminates the unlimited risk and allows you to benefit from further upward movement. If the stock continues to rise, the new bull call spread setup could result in additional profits compared to the original ratio spread.
- Roll the short call to a higher strike price. This adjustment assumes the bullish trend will reverse, and although it pushes your breakeven point higher, it does not eliminate the potential for unlimited loss.
If the price of IWM exceeds the short calls and you want to prolong the trade, consider closing and reopening it with a later expiration. This could incur costs and add risk, especially if the new setup creates a net debit greater than the spread’s width. Be cautious to ensure profitability when rolling forward.
Consider Time Decay and Implied Volatility
Time decay and implied volatility are two essential aspects to understand in a call ratio spread. Time decay, or theta, works in your favor by reducing the value of the two short calls as expiration nears, allowing you to potentially buy them back cheaper. In typical call ratio spread trade, reduced time value benefits the position if the underlying stock remains steady.
Implied volatility also plays a crucial role; as it decreases, the option premiums drop, particularly impacting the short calls. Ideally, initiate the ratio spread when implied volatility is high, maximizing profit as volatility decreases later.
Building a Back Call Ratio Spread
Everything mentioned above refers to the front call ratio spread. However, you may also opt for a reverse (or back) call ratio spread. This variation is ideal if you expect a stock’s price to remain stable ot increase. Here’s how you can set it up:
- Sell 1 At-the-Money (ATM) call: This establishes the short leg of the spread and generates a credit.
- Buy 2 In-the-Money (ITM) calls: These options provide additional exposure to the stock’s upward movement, creating the reverse ratio spread.
In a specular way compared to the front ratio spread, this setup aims to benefit from a sideways movement or a slight upward price movement, and it still involves selling first and then buying more options later. Just like the front ratio spread, the back call ratio spread can remove the upside risk. Your maximum loss remains unlimited, just like the front version of this strategy.
