Call Ratio Spread Explained
26 May 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.