Call Ratio Spread Explained

What is Call Ratio Spread?

The Call Ratio Spread is a premium neutral strategy that involves buying options at lower strikes and selling higher number of options at higher strikes of the same underlying stock.

When to initiate the Call Ratio Spread

The Call Ratio Spread is used when an option trader thinks that the underlying asset will rise moderately in the near term only up to the sold strikes. This strategy is basically used to reduce the upfront costs of premium paid and in some cases upfront credit can also be received.

How to construct the Call Ratio Spread?

Buy 1 ITM/ATM Call

Sell 2 OTM Call

The Call Ratio Spread is implemented by buying one In-the-Money (ITM) or At-the-Money (ATM) call option and simultaneously selling two Out-the-Money (OTM) call options of the same underlying asset with the same expiry. Strike price can be customized as per the convenience of the trader.

Strategy	Call Ratio Spread
Market Outlook	Moderately bullish with less volatility
Upper Breakeven	Difference between long and short strikes + short call strikes +/- premium received or paid
Lower Breakeven	Strike price of long call +/- Net premium paid or received
Risk	Unlimited
Reward	Limited (when Underlying price = strike price of short call)
Margin required	Yes

Let’s try to understand with an Example:

NIFTY Current market Price	9300
Buy ATM Call (Strike Price)	9300
Premium Paid (per share)	140
Sell OTM Call (Strike Price)	9400
Premium Received	70
Net Premium Paid/Received	0
Upper BEP	9500
Lower BEP	9300
Lot Size	75

Suppose Nifty is trading at Rs 9300. If Mr. A believes that price will rise to Rs 9400 on expiry, then he enters Call Ratio Spread by buying one lot of 9300 call strike price at Rs 140 and simultaneously selling two lot of 9400 call strike price at Rs 70. The net premium paid/received to initiate this trade is zero. Maximum profit from the above example would be Rs 7500 (100*75). For this strategy to succeed the underlying asset has to expire at 9400. In this case short call option strikes will expire worthless and 9300 strike will have some intrinsic value in it. However, maximum loss would be unlimited if it breaches breakeven point on upside.

For the ease of understanding, we did not take in to account commission charges. Following is the payoff schedule assuming different scenarios of expiry.

The Payoff Schedule:

On Expiry NIFTY closes at	Net Payoff from 9300 Call Bought (Rs)	Net Payoff from 9400 Call Sold (Rs) (2Lots)	Net Payoff (Rs)
8900	-140	140	0
9000	-140	140	0
9100	-140	140	0
9200	-140	140	0
9300	-140	140	0
9350	-90	140	50
9400	-40	140	100
9450	10	40	50
9500	60	-60	0
9600	160	-260	-100
9700	260	-460	-200
9800	360	-660	-300
9900	460	-860	-400

The Payoff Graph:

Impact of Options Greeks:

Delta: If the net premium is received from the Call Ratio Spread, then the Delta would be negative, which means slight upside movement will result into loss and downside movement will result into profit.

If the net premium is paid then the Delta would be positive which means any downside movement will result into premium loss, whereas a big upside movement is required to incur loss.

Vega: The Call Ratio Spread has a negative Vega. An increase in implied volatility will have a negative impact.

Theta: With the passage of time, Theta will have a positive impact on the strategy because option premium will erode as the expiration dates draws nearer.

Gamma: The Call Ratio Spread has short Gamma position, which means any major upside movement will impact the profitability of the strategy.

How to manage risk?

The Call Ratio Spread is exposed to unlimited risk if underlying asset breaks higher breakeven; hence one should follow strict stop loss to limit loses.

Analysis of Call Ratio Spread:

The Call Ratio Spread is best to use when an investor is moderately bullish because investor will make maximum profit only when stock price expires at higher (sold) strike. Although investor profits will be limited if the price does not rise higher than expected sold strike.