Options Trading Made Easy: Ratio Call Calendar Spread

The ratio call calendar spread is a strategy that’s ideal for a market that has stalled for the near term, but is due for a rise thereafter.
The rationale for the trade is to sell near-term calls for a hefty premium and have them expire worthless. The funds garnered from the short calls are then used to purchase fewer, longer-dated calls that move deep into the money upon expiry for a substantial profit. The trade is normally written for a credit.
That’s the way it’s supposed to work. But real life, of course, is never so simple. Let’s examine a real trade now to better understand the advantages and potential pitfalls of the ratio call calendar spread.
Below is a chart of fast-food retailer Yum Brands (NYSE:YUM) during a select six-month period:

Yum Brands had a cataclysmic decline in July, falling nearly 20% in just two weeks over profit fears (in red). The outlook was glum, and talk in the financial press was focused on the inevitability of further declines.
Your research and thinking told you different, however. And while you believed the stock might set new lows in the near term, you firmly believed the shares would be higher three months out.
After waiting for the stock to consolidate, you decided to launch a ratio call calendar spread, as that strategy offered the best means of playing the expected near-term drift followed by a bullish burst – and could be set for little or no cost.

Six Weeks in a Tight Range

It’s the last week of August when you ultimately take aim. The shares have done nothing for a week and a half and sit at exactly $73 when you:

1. Sell three September 73 calls for $2 each; and
2. Use the proceeds to purchase two January 73 calls for $2.80 apiece. Your net credit for the trade is $0.40.

Your call is dead-on regarding the lack of volatility in the near term. Yum trades a full six weeks between $71 and $73 (blue box), save a single day of downside indigestion, and your short calls close out-of-the-money worthless on the third Friday of September.
You’re now scot-free. With a guaranteed minimum $40 profit on the trade (from the initial premium), you’re free to sit back to watch the show. Yum can drop as low as it wants and you’ll still come out ahead.
As it turns out, the stock tests your patience in early October, falling below $66 and leaving you wondering whether you should close the long calls for a few extra dollars’ worth of time value.
In the end, you don’t, and you’re rewarded. Yum expires in November at $76.50, your two calls are in the money by $3.50 each, and you walk away with $740 ([$7 + $0.40] x 100).

Worst-Case Scenario

There are too many variables to determine definitively the trade’s maximum loss or break-even points. Traders should know that a worst-case scenario would occur if the stock spiked deep into the money prior to the first expiry, putting the short calls in a crushing loss position, then rebounded to close out of the money with the expiration of the long call.
In such a case, traders should close out the trade at the point where the losses on the short calls equal the value of the long calls plus the initial premium.

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