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The call ratio spread is officially considered a “neutral” strategy, as it produces maximum profits when the underlying security rises marginally by expiry. But the truth is, the strategy is also very flexible, and produces gains even if there is no movement in the underlying – or even if it falls.
The only way to lose money on a call ratio spread is if the underlying rises inordinately. At that point, losses on the trade become theoretically “unlimited.”
For that reason, it’s important that novices to the world of options investing not attempt to implement ratio spreads – at least not without the helping hand of an experienced trader. For those in need of a primer on ratio spreads, please see this introduction to ratio spread writing.
But now let’s delve into the details of the call ratio spread strategy.
Leg by Leg
Like all ratio spreads, the call ratio spread consists of two legs: the purchase of one at-the-money call, and the sale of multiple out-of-the-money calls. The exact ratio of long to short calls and the strike prices selected will, in the end, determine the overall success of the trade.
Let’s examine a real-life trading scenario to get a better feel for what’s involved.
This is a chart of the Ford Motor Co. (NYSE: F) after a particularly steep run-up in price.
Despite the stock performing wonderfully, you estimate a sideways move is now in the cards and begin to look at potential strategies to exploit such a neutral trading scenario. And because your research indicates there’s little chance of the stock retracing – but that it could still add a point or two – you settle on a bull ratio spread.
With Ford shares selling at $16.50 you open the trade (red circle). You buy one October 16.50 call for $2 and sell three October 17.50 calls for $1.25 each. Your total credit on the trade is $1.75.
And there was much rejoicing!
The subsequent trading action is just as you expected: sideways to slightly higher. At October expiry, Ford is trading at precisely $17.50. You hit it bang on. Your long call is $1 in the money and your three short 17.50 calls expire worthles at the money.
Your total take on the trade is $275 ([$1.75 + $1] x 100). Not bad for 60 days and nothing down.
Downside Risk
As with all trades, there’s some risk involved in a call ratio spread. The trade produces its maximum loss if the stock breaks hard to the upside, at which point the losses of the three short calls begin to overwhelm the single long call’s gains.
For this trade, that number arrives at roughly $18.88, at which point the long call is $2.38 in the money and the three short calls are each $1.38 in the money, producing a gain of $4.13 on the one hand (including the initial credit: $2.38 + $1.75), and a loss of $4.14 on the other.
The stock can trade as low as it wants, on the other hand, and you’ll still profit. Below the price of the long call ($16.50) everything expires worthless, leaving you the initial $175 premium as winnings.
Good luck!
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