Article

Call Ratio Spread Explained

14 Jul 2017 Nilesh Jain

New Page 1

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.

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Beginner's Corner

Call Ratio Spread Explained

14 Jul 2017 Nilesh Jain

New Page 1

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.