Call Ratio Spread Explained

Nilesh Jain

26 May 2017

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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Why to Choose Mutual Funds Instead of Directly Investing Into Equities?

Whether to invest in equities or mutual funds is a question that has plagued every investor. As someone who needs the best value for his/her investment should you invest in equity directly or via mutual funds?

Let’s start by first understanding what these two terms ‘equities’ and ‘mutual funds’ stand for-

Equities- Equities generally represent ownership of a company. If you own any equity in a company, you are a part owner of the said company (depending on how much equity you own).

Mutual Funds – It is an investment scheme which is professionally managed by an asset management company. It pools together the resources of a group of people and invests their money in equities, debentures, bonds and other securities.

Why choose mutual funds over equities?

For people who’ve never invested in either stocks or mutual funds, it is hard to know which is better and where to start. Broadly speaking, if you are a novice investor, mutual funds are not only less risky but also way easier to manage. Here are some ways in which investing in mutual funds is beneficial as opposed to investing in equities -

Diversification

Mutual funds provide more diversification as compared to an individual equity stock. When you invest in equity, you are investing in a single company which has its inherent risk. For example, if you invest Rs.20,000 in buying equities of one company, you could face a total loss if that particular company performs poorly in the market.  

If you invest the same amount in mutual funds, it will be invested in different kinds of stocks and financial instruments, high-risk and low-risk both, so you might not face total loss even if one company does poorly.

Scale of Investment and Lower Costs

For an individual investor buying and selling stocks is a difficult task due to its high price. Thus, any gains made from stock appreciation are nullified if the overall trading costs are considered. Comparatively with mutual funds, as the money is pooled from a large number of investors, the cost per individual is lowered.  

Another advantage of mutual funds is that you don’t need to invest large sums of money. Buying equities for a profitable venture needs huge amounts of money, a minimum of few lakhs. With mutual funds, you can start with Rs.1000 and earn profits on that as well.

Convenience

Keeping an eye on the markets everyday is a time-consuming business, especially if you are investing as a side gig. There are people who spend their lives studying the market and still end up sustaining heavy losses. Though investing in mutual funds does not guarantee high returns, it is stress-free and needs less work as compared to investing in equities.

To sum it up

It is important to remember that mutual funds have their own disadvantages as well. Thus, as with any financial decision, educating yourself and understanding the suitability of all the available options is the ideal way to invest. 


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Call Ratio Spread Explained

Nilesh Jain

26 May 2017

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.

Have Referral Code?