Call Ratio Back Spread Strategy

Next, we will learn a ‘Call Ratio Back Spread Strategy.’

Ratio strategies are special types of strategies which are devised when we don’t want to pay a time value of options.

Let’s break the name of the strategy Call Ratio Back spread and understand what does it mean and imply.

Ratio Spread strategy – can be broken in 2 parts. Ratio and spread.

Spread as we have already discussed before, means simultaneously buying and selling of options of the same category but at different strike price and same expiry.

Ratio means that when these buying and selling of options are done in a particular ratio. i.e. trading different quantities of calls or puts.

Assume we buy calls – say 1 lot and simultaneously sell calls – maybe 2 lots. We are basically buying and selling options simultaneously of the same category but different quantities.

When do we initiate a Call Ratio Back spread strategy?

This strategy is initiated when we have a view on the underlying in addition to the volatility expectation about the market. Volatility judgement plays a key role in the success of this strategy.

The Call Ratio Back Spread is a 3 leg option strategy. It involves

Buying 2 OUT OF-THE-MONEY (OTM) call option
Selling 1 IN-THE-MONEY (ITM)/ AT-THE-MONEY (ATM) Call option.

2:1 ratio is the classic ratio followed, However we can use multiples of the same. It means 2 options bought for every one option sold, or 4 options bought for every 2 options sold, so on.

This strategy should be devised when the trader is:

Very Bullish on the underlying asset.
Volatility is expected to increase to a great extent.

The Payoff from the strategy:

Unlimited profit if the market goes up
Limited profit/ or loss if market goes down
A predefined loss if the market stay within a range

So to make money by this strategy the market has to move big.

Usually, the Call Ratio Back Spread is deployed for a ‘net credit’ or net inflow of premium. The ‘net credit’ is what we make if the market goes down, as opposed to our expectation of the market going up.

On the other hand if the market indeed goes up, then we make an unlimited profit.

Example

Assume Nifty Spot is at 16743 and you expect Nifty to hit 17100 by the end of expiry. This is clearly a bullish outlook on the market.

To implement the Call Ratio Back Spread –

1.Sell 1 lot of 16600 CE (ITM)
2.Buy 2 lots of 16800 CE (OTM)

We need to make sure that –

1.The Call options belong to the same expiry
2.The Call options belong to the same underlying
3.The ratio of the strategy is maintained

16600 CE, one lot short, the premium received for this is ₹201/-

16800 CE, two lots long, the premium paid is ₹78/- per lot, so ₹156/- for 2 lots

Net Cash flow is = Premium Received – Premium Paid i.e. 201 – 156 = 45 (Net Premium Inflow )

With these trades, the call ratio back spread is executed. Let us check what would happen to the overall cash flow of the strategies at different levels of expiry.

So we see, as the market goes up, so do the profits, but when the market goes down, you still make some money, although limited.

Important pointers of the strategy which we can see here are:

Spread = Higher Strike – Lower Strike
16800 – 16600 = 200
Net Premium Inflow= Premium Received for lower strike – 2*Premium of higher strike
201 – (2*78) = 45
Max Loss = Spread – Net Premium Inflow
200 – 45 = 155
Max Loss occurs at Higher Strike.
16800
Max Profits =Unlimited as the prices rise above the higher strike price
Lower Breakeven = Lower Strike + Net Premium Inflow
16600 + 45 = 16645
Upper Breakeven = Higher Strike + Max Loss
16800 + 155 = 16955

Volatility increase in the underlying is good for this strategy. When you are extremely bullish in an underlying or any news upcoming, then this strategy will give good returns.

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