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What is a call ratio back spread option strategy

16 Jun 2023

What is the Call Ratio Backspread Option Strategy? 

  • The call ratio backspread option strategy is a popular bullish trading technique that enables you to benefit from potential price rises.
  • This strategy seeks to limit losses and maximise gains by combining the purchase of numerous call options with the sale of a smaller number. 
  • The call ratio backspread option strategy involves simultaneous buying and selling of call options. Its name originates from the ratio and structure of the trade.
  • In this strategy, you purchase two out-of-the-money call options and sell one in-the-money call option with the same underlying security and expiration.
  • Investors who are moderately bullish on the security’s price and expect an increase in volatility, employ this strategy to profit from a jump in its price.

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What are the Components of the Call Ratio Backspread Strategy?

To fully comprehend this strategy, let’s understand its key features:

  • Ratio: The strategy follows a 2:1 ratio, with two long call options and one short call option.
  • Strike selection: You can typically choose out-of-the-money call options for the long positions and an in-the-money call option for the short positions.
  • Same expiration date: All call options involved in the strategy must have the same expiration date, providing sufficient time for the position to work in your favour.
  • Bullish outlook: This strategy is deployed by bullish investors who anticipate a significant price increase in the underlying security.

How are Profits and Losses Determined?

  • The call ratio backspread strategy offers unlimited profits and limited losses. Here's how the calculations work:
  1. Break-even point: The break-even point is calculated using the formula 2 * (long call strike) - short call strike +/- net premium. If there is a net premium inflow, an additional break-even point is added.
  2. Maximum profit: The maximum profit is theoretically unlimited due to the rise in the price of the underlying security.
  3. Maximum loss: The maximum potential loss is determined by the difference in strike prices between the long and short call options, along with the net premium paid.
  1. Illustration: Let's consider an example to illustrate the call ratio backspread strategy

Underlying Security - Nifty50

Strategy:

Sell Call: Strike 6,500 (Premium: ₹375)

Buy Call: Strike 7,000 (Premium: ₹175)

Buy Call: Strike 7,000 (Premium: ₹175)

Net Premium: ₹25

  1. Maximum loss: In this strategy, the difference between the two strikes is 500. To calculate the maximum loss, we subtract the net premium received from the spread and multiply it by the lot size: (500 - 25) * 50 = -₹22,500.
  2. Break-even points: The lower breakeven point is determined by adding the premium received to the strike price of the sold call option: 6,500 + 25 = 6,525. On the other hand, the upper break-even point is found by adding the maximum loss to the strike price of the higher long call option: 7,000 + 475 = 7,475.
  • To profit from this strategy, the Nifty 50 needs to trade below 6,525 or above 7,475.
  • By adjusting the strike prices and premiums, you can apply the three-legged call ratio backspread option strategy to various stocks or indices. 

What are Some Variations and Considerations to Keep in Mind?

  • You can modify the call ratio backspread strategy to increase leverage and gains. Variations include changing the ratio to 3:2 or 3:1.
  • Adding more long call options amplifies profits during significant upward movements in the underlying security price.
  • However, this strategy requires active monitoring and is best suited to retail investors with substantial knowledge of options trading.
  • Additionally, you may filter stocks with higher-than-average volatility to identify suitable candidates for the strategy.

Is Call Ratio Backspread Strategy Right for You?

  • This strategy offers a bullish approach to options trading.
  • By strategically combining the purchase and sale of call options, it limits losses while maximising gains.
  • However, before deciding if this strategy is suitable for you, carefully consider its components, profit-and-loss calculations, and any variations.
  • Assess your risk tolerance and familiarity with options trading before implementing this strategy.

 

 

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